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BIS - 2000 - 6/5/00

Veon: Last year you helped me with the flow chart - how is the financial stabilityis it meeting the goals and objectives as you thought with bringing together all of the actors together

SA: I think it has == it has been a busy first year. We have several working groups which have met, a fairly large of concrete recommendations and I think what is now important is implementation and the Forum will be judged by how these recommendations can be implemented.

How will they be implemented

SA: They are of two types: Either two types: things which need to be implemented by international institutions and organizationsthe IMF/World Bank and so or the Ball Commission or by implementation by national authorities whether they need action by governments or parliaments and in other cases, implementation by domestic regulators and supervisors.

Veon: Is consensus being achieved with all of the various levelsit must be workingthere is no problem politically people are coming together to say "hey look, we need some kind of coordination for the benefit of us all?"

SA: Yes. It is important to keep in mind that aside from having had these three - six working groups on issues, the Forum brings together information on what everybody is doing and talking about. What are they doing, is this on the right track, who needs to talk to each other to proceed efficientlythat is working and that does not result in something which comes out of the forum but is an integral part of the process. That we think is very helpful.

There is an exchange of information on vulnerabilities affecting the system. I told you that last year that all these different bodies here and the national authorities have information on bits and pieces off what is happening in the international financial system that is a potential concern. However, it is not possible for any one of them to have a full view. There might be a concern that someone is aware of or who has a concern that someone is looking at to put their ideas together.

Veon: You have created a Forum which does not see the tree but the forest?

SA: Both Because the Forum is comprised of reasonably like-minded countries, has a pretty god idea of what the forest should be in so far as the official sector is concernedclearly people have different view as to what the issues are but it certainly has such a range of varying participation of those who cast their eyes very widely that hopefully we are not missing individual trees.

Veon: Was this a way to help bring together the macro and micro in a more manageable way globallywe are being integrated walls came down in the 70's and 80's financially, the cross boarder mergers and acquisitions, the foreign direct investment growingwas this an attempt to merge and bring the macro and micro together.

SA: Yes. The focus is on the micro regulator prudential aspect. The principle way of looking at this is that you don't have regulation for the sake of regulation but for a macro economic perspective. For example, you say, "We want to ensure systemic stability, we want to have market which operate with integrity because markets which operate with integrity have greater activity, and operate more efficiently". These are the objectives to which regulation and supervision should strive. Sometimes you can have micro prudential regulation which might make sense for individual institutions but in the aggregate, they can have unintended adverse macro economic affects. I think the forum was created with things of this sort in mindto make sure that regulators are aware of the perspectives of those whose responsibility is macro-economicbroad overview and aggregate and likewise make macro economic policymakers aware of the constraints by which the regulators operate and marrying these two perspectives to have the best regulatory policies which we could have. This forum does not discuss whether or not the Federal Reserve should raise interest rates.

Veon: I have already spoken to Ferguson about that. Based on what has gone on in the economy in the last 18 months, do you think that it was fortuitious to bring the Forum together when you did. Could the system have waited or was it timely?

SA: It was definitely timely. The kinds of thoughts which lay behind the forum began to be expressed in 1995-1996 when the Mexican Tequila crisis and the 1997-1998 Asian Crisis made it ever more clear that it was needed. There is a big danger about slipping into complacency about dressing the lessons of the various crises. This is always the case. The forum exists to ensure that it does not happen. We hope that it will keep the spotlight on issues by involving all of the various authorities who have responsibilities or roles to play in this respect to see that things are done.

Veon: When you look at the total world system and you look at the United States where there are grave concerns about high pe ratios, high debt, unsustainable growth then Europe and the drop in the euro and high unemployment and then Japan which has a whole set of problems there, do you have any assurances that the system will stay together. What could bring the system down? Do you talk about that?

SA: All the time. No one can predict what will bring the system down. Any kind of combination of factors at a bad time or the right time might or whatever, might be sufficient to trigger a set of reactions that have very adverse consequences. Typically these will be some event in the macro- economic conjunctional picture that triggers any shock of some kindthat triggers behavior which flushes out structural weaknesses in the system which we are not aware of and then things start to snowball. So we go looking for those thingssystemic weaknessesvulnerabilities and we try to say, "Is this an important thing? Are there ways in which it could become important? How should we do this?"

Veon: I had an interview with a gentlemen at the IOSCO meeting four or five years ago and I remember Ciampi sayings, "If we put all of these rules and regulations in place , nothing will happen." I said to this gentlemen in a one to one chat who was on the executive committee, "If this is happening over here and this is happening over there, how can you know what the left and right hands are doing all time, if you don't know what is going on globally?" What I am now understanding is that is what the forum is looking to do.

SA: It is. But I should hasten to correct that the Forum is not about expanding the regulatory net and the corpus of regulations, it isn't. I think regulators have come to understand that simply regulating is not going to change anything and therefore you need to change behavior and look at incentives for different types of behavior. We are seeking ways of instilling incentives that go in the direction of behavior which is compatible with sound financial institutions and sound financial markets. There are times when existing regulation is counter to that and this is also about removing unhelpful regulation and considering what is the appropriate form of regulation and I think with the market environment the technological developments which we have now, you have to be very, very careful thinking about regulating and regulating, and so on. That said, there are certain areas in which I think all regulators would tend to say, "We have ceratin objectives of regulation and therefore associated principles which areyou have to drive a pole down into the ground and say, "This stands independent of development" in which case you have to find a way of shaping development and behavior as it changes in ways that is compatible with our objective. This is tricky. All the regulators are now of the view, more than before, that regulation has got to be very sensibly thought out in order not to become circumvented by the various ways the markets have to circumvent [did not hear word].

VEON: Mr. Crockett mentioned that there is a great concern about the "herd mentality" in the U.S. As you know we had a deep run up then a deep correction, last week we had a run up based on the premise that interest rates probably, which is not ture at this moment, the bottom line is that we cannot continue this unsustainable behavior. How do you change the behavior....

S.A. I am not sure I agree with him on that...although he is my boss.

Veon: My concern is that everyone looks at their account and they feel good if it is up and bad if it is down. Based on what happened in April, people are not feeling good...last week they said we had an 18% run up...the hard landing might come as a result of the herd mentality...Americans have a high level of debt ....

SA: There is no doubt about the herd mentality in financial markets. There has been herd mentality in financial markets for as long as they have existed. The Dutch Tulip Mania was a herd kind of thing. Now we have many more individuals owning assets that are suseptible to market changes. They have a much greater direct control with their marketable investment positionsthe ability to trade, buying shares, and so on. You go 25-30 years back, most people had a pension fund in which they had nothing to do with and they also had deposit accounts. So that has all changed. More individuals making decisions, perhaps that more individuals that have more information than was the case when funds were managed by a small group of investment advisers. Then you have the technology which has made it all available and information for people to act on. All of this creates the basis for there to be herding types of reactions and it seems to me that there are fallacies of composition. While an individual might do in his own account as to what is rational or seems rational but when everybody does the same thing, such as selling to get out of the market, it is obvious that very quickly you will exhaust the markets ability to find buyers on the other side with asset prices falling more than they need to in fundamental terms and likewise when the crisis is over, everybody rushes in to buy and everybody is on one side of the market. It is very difficult to think of what you could do to discourage that. If you have decided that it is a useful thing to have optimistic decisions made by individuals and you provide them with the opportunity to affect their decisions by trading on the internet, these things will tend to be unavoidable. That concerns the retail investor. Then there are the big institutions which might act also on the same information at the same time, and you could say "they ought to know better," and they can be regulated in some cases. But it is difficult to regulate a way institutions doing the same thing at the same time. You could not say, 10% of holders of Microsoft have sold and since the market cnnot absorb more than 10% on a given day, you can't sell if you have not already done so. One of the things that happened in the Asia crisis is that when large institutional investors could not sell Malaysian stocks, they sold Hong Kong stocks in order to lessen their total risk exposure to Asia. You cannot micro-manage institutions. So this is something we have to live with and I think the focus needs to be far more on making sure that the defenses are in place at financial institutions, so they can deal with these episodes. We cannot have volatility which causes bankruptcies and crashes, we may have to accept this but we cannot accept it when we have volatility that institutions go bankrupt and countries get busted. That means raising standards of safety and soundness all over the place. There are things which come into this at the retail level as well. Customer education, I guess is an important part. It is very important throughout the financial system to increase risk sensitivitymake people aware that there are risks to being a participant in internaitonal markets for a 107 month period. So by increasing risk sensitivity and ABILITY to withstand shocks you will have accomplished almost as much as you can do.

Veon: You have described what I call the root beer theory. In the root beer theory, in my opinion, you pour a glass and you have the liquidthe long termthe estate, pension plan. The foam happens to be the day traders and the $1.7T running around the world on a daily basis looking for the highest play. When I was in Davos, I asked a number of people who were on a panel called "" Arthur Levitt if we have the root beer mentality, what happens when the foam gets bigger and biggerat what point do you lose the safety of the long term investor because they now say, "Wait a minute, I am taking the impact of what these guys are doing up there."

SA: That is a source of possible concern because if there is so much volatility in markets that long-term institution investors start losing faith in these markets, then the amount of capital in these markets will be greatly diminished. I think one has to distinguish a couple of things related to tech stocks and the New economy: (1) We have new possibilities for trading which is much easier and that is what has made day trading possible, (2) almost a requirementyou have had a whole lot of new stocks traded which unlike the new stocks trade in the old days, do not have a sound or accepted valuation methodology for them. There has been, just to digress. In the old days, a company in order to be listed on the stock exchange had to demonstrate that they had a quality of earnings, that they had a qhole year minimum of disclosed profits and other kinds of things. You were not permitted to be traded until you had demonstrated criteria. With the tech stocks there has been a tremendous desire to facilitate these companies access to capital and listing requirements in various stock markets have come down to make this possible. You have Nasdaq in the U.S., the emerging market technologies in the UK, there is the Noiamark in Germany for tech stocks, and a similar thing in Hong Kong, and all the major markets which have created market environments in which the listing requirements are lower than what they were for traditional initial public offerings. For these companies, valuation uncertainties are much greater. I am sure you have heard all about the tech stocks. So you have the basis for much more volatility. I think in the tech stock market last week, the market has no particular anchor so the tech markets are all driven by people's optimism or there is no middle. Combine with this, there is very little supply of these stocksmost companies issue 10 or 18% of their total stocks so there is a very limited number of shares being traded. That means that many of the conditions for the day traders are being satisfied because THEY NEED TO HAVE VOLATILITY TO MAKE MONEY. It means that day trading is trading a limited number of stocks in any given amount of demand will cause a lot of volatility. When you have high volatility, the idea of getting in and out in a given day makes sense if you have hardly any price movement. None of them could do it because you would need millions of dollars in order to make any money if the prices changes are 2% but if they are 20-30-40% a day, then you need a lot less to make money to make a given return. So there are a bunch of factors which have come together to create the day trading on markets. Is that something that will always be there? Maybe not? Once this asset class becomes one that is better understood then the market s find brad consensus on how they should be valued or once they become issued in greater numbers or more of them to differentiate one from the other. More experience and information to value them, some of this volatility will die away in which case day traders will have less impact on markets.

Veon: They are wreaking havoc. The person who has their money in the market and who has gone into tech stocks because after all that's the place to make more than 10 or 12% in a blue-chip stock....

SA: That is part of the problem. Ten to twelve percent is a heck of a lot in the economy when real economies are going at 4%. As economists, we talk about real rate of return in the economy and they cannot be in the aggregate greater than the growth of the economy as a whole so when large numbers of people in the economy fell stocks will generate year after year, 10=12-15-20% rates of return, something is wrong. Stocks you know are claims on the profits of the companies. If that grows geometrically ever after, the other part of gross national incomecompensation to resources used by companies will get nothing.

Veon: That's very interesting. Somehow with what has happened in America, a 30% return is not going to go on indefinitelyGeorge Soros said to expect 15% instead of 30%.

SA: Soros might be able to return 15% for the general populace to have earnings expectations of 15% a year is ludicrous.

Veon: Do you see with regard to rising debt levels in Americabut looking at Asia, corporate buyouts and Japan, is there a concern with global liquidity?

SA: Meaning too much money creation Veon: Too little there is more debt than money SA: All money is debt: Veon: true, yes. SA: So if you have too much debt, you have too much liquidity. Liquidity is that enables somebody to realize somethingthe desire to purchase something, to get material to build, to buy a company. Whether they have saved up the money or most often are able to borrow money to realize it, after a period in which you have a lot of easy money with low interest rates, indebtedness builds up and it often as in the past, when the business cycle matured, just at a time that the business starts to turn, to get the business cycle going, businessmen have to build up inventory by borrowing and therefore, indebtedness rises ahead of general economic activity. The more debt you take on the greater the financial burden on any given business enterprise. Then over the business cycle, there comes a stage when interest rates start to rise in a big way. Every increase in interest rates increases the cost of indebtedness. At the same time, your sales might be flattening out so you as a n individual corporation will have diminished profits and a greater burden of carrying debt. That causes companies to invest less and is the beginnings of the slowdown in households or postpone decisions to move or to buy a new car. When the economy slows, there is a lot of unpaid indebtedness, then economies get into trouble because people cannot service their debt. Banks get into problems and when banks get into problems, they lend much less and the problems start to snowball.

Veon: Do you see this as being a problem right now? You are really painting the picture of where we are today.