** Greenspan ** Now what in the world is this guy thinking about by making such a speech in the middle of October at a time when the market is so vulnerable?
Remarks by Chairman Alan Greenspan
Before a conference sponsored by the Office of the Comptroller of the Currency,
Washington, D.C.
October 14, 1999
Measuring Financial Risk in the Twenty-first Century
One of the broad issues that you have been discussing today is the nature of financial risk. This
evening I will offer my perspective on the fundamental sources of financial risk and the value
added of banks and other financial intermediaries. Then, from that perspective, I will delve into
some of the pitfalls inherent in risk-management models and the challenges they pose for risk
managers.
Risk, to state the obvious, is inherent in all business and financial activity. Its evaluation is a key
element in all estimates of wealth. We are uncertain that any particular nonfinancial asset will be
productive. We're also uncertain about the flow of returns that the asset might engender. In the
face of these uncertainties, we endeavor to estimate the most likely long-term earnings path and
the potential for actual results to deviate from that path, that is, the asset's risk. History suggests
that day-to-day movements in asset values primarily reflect asset-specific uncertainties, but,
especially at the portfolio level, changes in values are also driven by perceptions of uncertainties
relating to the economy as a whole and to asset values generally. These perceptions of broad
uncertainties are embodied in the discount factors that convert the expectations of future earnings
to current present values, or wealth.
In a market economy, all risks derive from the risks of holding real assets or, equivalently,
unleveraged equity claims on those assets. All debt instruments (and, indeed, equities too) are
essentially combinations of long and short positions in those real assets. The marvel of financial
intermediation is that, although it cannot alter the underlying risk in holding direct claims on real
assets, it can redistribute risks in a manner that alters behavior. The redistribution of risk induces
more investment in real assets and hence engenders higher standards of living.
This occurs because financial intermediation facilitates diversification of risk and its redistribution
among people with different attitudes toward risk. Any means that shifts risk from those who
choose to withdraw from it to those more willing to take it on permits increased investment without
significantly raising the perceived degree of discomfort from risk that the population overall
experiences.
Indeed, all value added from new financial instruments derives from the service of reallocating risk
in a manner that makes risk more tolerable. Insurance, of course, is the purest form of this service.
All the new financial products that have been created in recent years, financial derivatives being in
the forefront, contribute economic value by unbundling risks and reallocating them in a highly
calibrated manner. The rising share of finance in the business output of the United States and other
countries is a measure of the economic value added from its ability to enhance the process of
wealth creation.
But while financial intermediation, through its impetus to diversification, can lower the risks of
holding claims on real assets, it cannot alter the more deep-seated uncertainties inherent in the
human evaluation process. There is little in our historical annals that suggests that human nature has
changed much over the generations. But, as I have noted previously, while time preference may
appear to be relatively stable over history, perceptions of risk and uncertainty, which couple with
time preference to create discount factors, obviously vary widely, as does liquidity preference,
itself a function of uncertainty. These uncertainties are an underlying source of risk that we too
often have regarded as background noise and generally have not endeavored to capture in our risk
models.
Almost always this has been the right judgment. However, the decline in recent years in the equity
premium--the margin by which the implied rate of discount on common stock exceeds the riskless
rate of interest--should prompt careful consideration of the robustness of our portfolio
risk-management models in the event this judgment proves wrong.
The key question is whether the recent decline in equity premiums is permanent or temporary. If
the decline is permanent, portfolio risk managers need not spend much time revisiting a history that
is unlikely to repeat itself. But if it proves temporary, portfolio risk managers could find that they
are underestimating the credit risk of individual loans based on the market value of assets and
overestimating the benefits of portfolio diversification.
There can be little doubt that the dramatic improvements in information technology in recent years
have altered our approach to risk. Some analysts perceive that information technology has
permanently lowered equity premiums and, hence, permanently raised the prices of the collateral
that underlies all financial assets.
The reason, of course, is that information is critical to the evaluation of risk. The less that is known
about the current state of a market or a venture, the less the ability to project future outcomes and,
hence, the more those potential outcomes will be discounted.
The rise in the availability of real-time information has reduced the uncertainties and thereby
lowered the variances that we employ to guide portfolio decisions. At least part of the observed
fall in equity premiums in our economy and others over the past five years does not appear to be
the result of ephemeral changes in perceptions. It is presumably the result of a permanent
technology-driven increase in information availability, which by definition reduces uncertainty and
therefore risk premiums. This decline is most evident in equity risk premiums. It is less clear in the
corporate bond market, where relative supplies of corporate and Treasury bonds and other
factors we cannot easily identify have outweighed the effects of more readily available information
about borrowers.
The marked increase over this decade in the projected slope of technology advance, of course,
has also augmented expectations of earnings growth, as evidenced by the dramatic increase since
1995 in security analysts' projections of long-term earnings. While it may be that the expectations
of higher earnings embodied in equity values have had a spillover effect on discount factors, the
latter remain essentially independent of the earnings expectations themselves.
That equity premiums have generally declined during the past decade is not in dispute. What is at
issue is how much of the decline reflects new, irreversible technologies, and what part is a
consequence of a prolonged business expansion without a significant period of adjustment. The
business expansion is, of course, reversible, whereas the technological advancements presumably
are not.
Some analysts have offered an entirely different interpretation of the drop in equity premiums.
They assert that a long history of a rate of return on equity persistently exceeding the riskless rate
of interest is bound to induce a learning-curve response that will eventually close the gap.
According to this argument, much, possibly all, of the decline in equity premiums over the past five
years reflects this learning response. It would be a mistake to dismiss such notions out of hand.
We have learned to no longer cower at an eclipse of the sun or to run for cover at the sight of a
newfangled automobile.
But are we really observing in today's low equity premiums a permanent move up the learning
curve in response to decades of data? Or are other factors at play? Some analysts have suggested
several problems with the learning curve argument. One is the persistence of an equity premium in
the face of the history of "excess" equity returns.
Is it possible that responses toward risk are more akin to claustrophobia than to a learning
response? No matter how many times one emerges unscathed from a claustrophobic experience,
the sensitivity remains. In that case, there is no learning experience.
Whichever case applies, what is certain is that the question of the permanence of the decline in
equity premiums is of critical importance to risk managers. They cannot be agnostic on this
question because any abrupt rise in equity premiums must inevitably produce declines in the values
of most private financial obligations. Thus, however clearly they may be able to evaluate
asset-specific risk, they must be careful not to overlook the possibilities of macro risk that could
undermine the value of even a seemingly well-diversified portfolio.
I have called attention to this risk-management challenge in a different context when discussing the
roots of the international financial crises of the past two and a half years. My focus has been on the
perils of risk management when periodic crises--read sharply rising risk premiums--undermine
risk-management structures that fail to address them.
During a financial crisis, risk aversion rises dramatically, and deliberate trading strategies are
replaced by rising fear-induced disengagement. Yield spreads on relatively risky assets widen
dramatically. In the more extreme manifestation, the inability to differentiate among degrees of risk
drives trading strategies to ever-more-liquid instruments that permit investors to immediately
reverse decisions at minimum cost should that be required. As a consequence, even among
riskless assets, such as U.S. Treasury securities, liquidity premiums rise sharply as investors seek
the heavily traded "on-the-run" issues--a behavior that was so evident last fall.
As I have indicated on previous occasions, history tells us that sharp reversals in confidence occur
abruptly, most often with little advance notice. These reversals can be self-reinforcing processes
that can compress sizable adjustments into a very short period. Panic reactions in the market are
characterized by dramatic shifts in behavior that are intended to minimize short-term losses. Claims
on far-distant future values are discounted to insignificance. What is so intriguing, as I noted
earlier, is that this type of behavior has characterized human interaction with little appreciable
change over the generations. Whether Dutch tulip bulbs or Russian equities, the market price
patterns remain much the same.
We can readily describe this process, but, to date, economists have been unable to anticipate
sharp reversals in confidence. Collapsing confidence is generally described as a bursting bubble,
an event incontrovertibly evident only in retrospect. To anticipate a bubble about to burst requires
the forecast of a plunge in the prices of assets previously set by the judgments of millions of
investors, many of whom are highly knowledgeable about the prospects for the specific
investments that make up our broad price indexes of stocks and other assets.
Nevertheless, if episodic recurrences of ruptured confidence are integral to the way our economy
and our financial markets work now and in the future, the implications for risk measurement and
risk management are significant.
Probability distributions estimated largely, or exclusively, over cycles that do not include periods of
panic will underestimate the likelihood of extreme price movements because they fail to capture a
secondary peak at the extreme negative tail that reflects the probability of occurrence of a panic.
Furthermore, joint distributions estimated over periods that do not include panics will
underestimate correlations between asset returns during panics. Under these circumstances, fear
and disengagement on the part of investors holding net long positions often lead to simultaneous
declines in the values of private obligations, as investors no longer realistically differentiate among
degrees of risk and liquidity, and to increases in the values of riskless government securities.
Consequently, the benefits of portfolio diversification will tend to be overestimated when the rare
panic periods are not taken into account.
The uncertainties inherent in valuations of assets and the potential for abrupt changes in
perceptions of those uncertainties clearly must be adjudged by risk managers at banks and other
financial intermediaries. At a minimum, risk managers need to stress test the assumptions
underlying their models and set aside somewhat higher contingency resources--reserves or
capital--to cover the losses that will inevitably emerge from time to time when investors suffer a
loss of confidence. These reserves will appear almost all the time to be a suboptimal use of capital.
So do fire insurance premiums.
More important, boards of directors, senior managers, and supervisory authorities need to balance
emphasis on risk models that essentially have only dimly perceived sampling characteristics with
emphasis on the skills, experience, and judgment of the people who have to apply those models.
Being able to judge which structural model best describes the forces driving asset pricing in any
particular period is itself priceless. To paraphrase my former colleague Jerry Corrigan, the advent
of sophisticated risk models has not made people with grey hair, or none, wholly obsolete.
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