Financial Stability in Emerging Market Economies
Speeches
01 Sep 1997
Financial Stability in Emerging Market Economies
Andrew Sheng, Deputy Chief Executive, Hong Kong Monetary Authority
(Speech at APEC Working Level Symposium on Strengthening Financial Systems in APEC Economies, Federal Reserve Bank of San Francisco)
Mr Timothy Geithner, Mr Chairman, Ladies and Gentlemen,
- I am delighted to join this Symposium and speak in the same
session with my good friend Gavin Bingham. The purpose of this
session is to present some thoughts on financial stability issues
in the light of growing capital flows. This is clearly an issue of
the highest priority, given what has been happening in the
Southeast Asian financial markets in recent months as a result of
the Thai crisis.
- My presentation this morning will be divided into two parts.
First, I will reiterate some points that I made recently in Kuala
Lumpur. These basically relate to the fact that although financial
markets are global, financial regulations, laws and all the
stresses and strains in terms of global capital flows are all local
in nature, so that the domestic banks bear the brunt of adjustment.
This is clearly the lessons from the recent experience in
Asia.
- The second part of my presentation will focus on implementation
issues relating to financial regulation. Thanks to Gavin who has
just given us an excellent and comprehensive overview of the Report
of the Working Party on Financial Stability in Emerging Market
Economies, I have a good background to build upon. Specifically, I
shall highlight four key areas:-
- First, the approaches to financial regulation
can be summarised along four major lines: internal governance,
official oversight, market discipline and robust financial
infrastructure. Internal management largely complements external
supervision and regulation. The practical means to improve
stakeholders oversight is through the right incentive structure and
market discipline. Despite all its faults, the market does work,
and the trick is how to make the market work better. Financial
stability, especially in emerging economies, depends not on
regulatory approaches that avoid risks or cap risks at the expense
of the state, which in economic terms means moral hazard. It is
more important to ensure that the market manages the risks more
efficiently. Modern supervisory approaches strongly involve greater
market transparency, so that not only do financial institutions
manage their own risks better, the market peer pressure will
enforce regulatory discipline on behalf of the regulator.
- Second, on addressing financial regulatory
issues, we see no shortage of initiatives. The Report of the
Working Party on Financial Stability in Emerging Market Economies
and the Basle Committee's Core Principles provide an excellent
roadmap for global financial stability. However, the question still
remains one of implementation. What early warning signals are there
to prevent crises? How do we avoid bureaucratic inertia that may
ignore these warning signals or delay the necessary cures? These
problems cannot be solved at the international level, but must be
addressed at the national level. Perhaps we should ask what
incentives or disincentives exist at the global level to assist in
the adoption of sound practices and providing assistance for the
development of robust and efficient financial structures in
emerging markets.
- Third, risk is getting so complicated that it
must be managed, at the institutional level, sectoral level and the
national level. While the Working Party felt that there is no one
checklist that covers all risks in all countries, as a practical
man, I find checklists helpful to identify where the risk
concentrations are. We have to be practical: there will always be
different ways of managing risks and different appetites for risks.
Let the market judge how the risks are perceived and managed.
- Fourth, not only must individual banks manage
their risks better, policy makers must manage the national risks
more effectively. This implies that they must have a "big picture"
of the risks that are concentrating or emerging for the economy as
a whole. Traditional risk management at corporate or sectoral level
may simply shift risks from one sector to another. Risks still
remain in the economy as a whole. Thus, the new approach in
financial regulation is all about national risk management.
Brave new world, old-fashioned credit risks
- In the last two decades, the global financial system has
witnessed dramatic changes that have brought about both higher
risks and rewards. At the end of the 1980s, I was engaged in a
survey of problem financial systems at the World Bank. I counted 33
countries that experienced financial fragility problems, but the
1996 IMF World Economic Outlook reported that out of 180 Fund
members, at least 130 suffered banking problems in the last 15
years, many of which surfaced in the 1990s.
- The structural changes in banking stem from a combination of
globalization, financial innovation, de-regulation and
liberalization that saw increased competition and capital flows. A
few simple numbers would illustrate what I mean. First, between
1986-96, global GDP increased by 42%, world trade by 92% to US$4
trillion, cross-border bank assets doubled to $8 trillion, daily FX
tradins increased to $1.3 trillion in 1995 (6 times the volume in
1986), and derivative market trading increased roughly 20 times. As
Bob Hope used to say, a billion here, a billion there and soon we
are talking about real money.
- Second, as a result of deregulation and the development of
capital markets, banks, insurance and the pension/asset management
business are functionally integrating, although banks are still
licensed separately. In the US, the mutual fund business is getting
almost as large as banking assets. Stock market assets are bigger
than banking assets.
- Third, financial innovation, particularly in the growth of
derivatives has introduced a whole new ball game of financial
instruments to manage risks. These new instruments also bring with
them added risks, as Mr Leeson amply demonstrated with
Barings.
- Fourth, I believe it was Bill Gates who made the interesting
point about technology and competition in banking: "in the 21st
century, banking will be important, but not necessarily banks." The
rise of the Internet has the potential to cut out significantly the
intermediation function of traditional banking, since consumers and
savers can go directly to the service provider. Software houses,
car manufacturers, telephone companies, and even cable TV providers
are getting into the online home banking and financial services
business. For instance, the cost of intermediation involved in
securitization is 50 basis points, compared to 200 basis points
using a traditional bank loan. Internet banking, provided the
security aspect can be sorted out, costs less than 1 cent per
transaction versus US$4 to clear a paper cheque in the US.
- All these structural developments widen the boundaries of
financial markets and add to increased competitive pressures, both
functionally, domestically and internationally.
- I put this in a global context because, as my former colleague
at the World Bank, Mr Jerry Caprio used to say, we're not in Kansas
anymore. The globalization of capital flows, as international funds
roam the world in search of higher returns and lower risks mean
that domestic financial systems absorb a tremendous amount of risks
without even being aware of the consequences of globalization.
Gerry Corrigan, former President of the New York Fed and Chairman
of the Basle Committee liked to point out that it was old fashioned
credit risks on the asset side of the balance sheet that more often
than not got a bank into trouble. On the other hand, financial
innovation has meant that banks are increasingly getting themselves
also into trouble on the liabilities side in the new world of
derivatives. How else can we explain that the Thai banking system
entered into US$23.4 bn of forwards, equivalent to nearly 15% of
GDP in a matter of days?
- As recent IMF studies have shown, the costs of financial
distress can be very large, with direct fiscal costs ranging from
10-20% of GDP, causing large scale devaluations and severe economic
adjustments. We all know that prevention is better than the cure,
so that financial regulation is the right thing to do. On the other
hand, although no good estimates are available on the costs of
financial regulation internationally, one private sector research
estimate puts the cost of financial regulation in the US as high as
7% of GDP, with the caveat that excessive regulation may stifle
innovation and productivity improvements.
- The globalization of banking means that increasingly banks have
to satisfy both national as well as international scrutiny and
oversight. This calls for national supervisors to apply world-wide
standards, so as to achieve a level playing field. Different
markets should adapt their respective legal framework to enable
bank and capital market regulators to cooperate and coordinate
better both domestically and internationally.
- All the new rules of the game are being spelled out in the
Basle Committee's 25 Core Principles, and the Working Party Report
on Financial Stability in Emerging Market Economies which Gavin has
just talked about. I would simply like to add a commentary to some
key facets which I feel deserve a bit more elaboration.
The Fallacy of Composition
- If we think through the key lessons of volatile capital flows,
and the fact that global financial markets comprise basically the
sum of domestic markets, we begin to understand that markets
actually make very basic mistakes of what is commonly called the
"fallacy of composition". If everyone believes something to be
true, the prophecy becomes self-fulfilling - that is, the herd
instinct pushes the price in that direction. To put it very simply,
many property developers make the mistake of borrowing short to
invest in long-term property. Bankers make the mistake of borrowing
short to lend long [especially in property or other asset markets].
And aggregately, some emerging markets make the mistake of
borrowing short-term capital flows to finance illiquid
non-tradeables, such as property, which cannot generate the foreign
exchange to repay foreign debt.
- This problem is compounded when inexperienced asset fund
managers collectively assume that investing in emerging markets
mean that you can get higher returns without some risks. In sum,
when it does not add up, there is no free lunch.
- What globalization has brought about is the fact that asset
markets are now managed as portfolios, so that foreign fund
managers look at an economy in terms of four major asset markets,
namely, bank deposits, equity, bonds and the property market. Asset
managers look at the quality behind each asset, their risks and
returns and while domestic asset holders may shift between internal
markets, global markets allow all asset holders (including foreign
investors) to shift to foreign assets when conditions are
unfavourable domestically.
- Thus, today domestic policy formulation cannot run independent
of all asset prices, namely, the interest rate, the exchange rate,
consumer prices and real estate prices. Whenever one market price
is not consistent with the fundamentals, and there are policy
conflicts, there are sufficient arbitrageurs out there to hedge or
arbitrage the price differences.
- This is particularly true of the foreign currency hedge, which
is provided by the domestic banking system. The pricing of that
hedge depends on the interplay of the interest rate and the
exchange rate. If, for whatever reasons, there is a conflict of
policy between these two prices as policy targets, then the
domestic banking system may misprice the premium of the hedge.
Since the central bank is both the lender of last resort as well as
the ultimate provider of domestic foreign exchange, there is the
risk that the policy conflict results ultimately in a loss in
foreign exchange reserves through intervention.
- The "fallacy of composition", which occurs because of
information asymmetry, causes markets to overshoot or undershoot,
adding to volatility. Thus, the only way to deal with this problem
is greater market information, disclosure and transparency. In
derivative terminology, if the assumptions about the underlying
asset behaviour are wrong, the value of the derivatives can be
mispriced very badly. It is the banker's job to manage his risks
well, hence the new emphasis on risk management models and systems.
A banker may have only a micro-picture of his risks, but his board,
shareholders and regulators must have a macro-view of where the
risks are concentrating. In other words, the market functions well
when information about the micro and macro risks in the system are
readily available to everyone.
- In this complex world, we can no longer assume that public
policy-makers or regulators have the best information. Given the
large element of uncertainty underlying technological progress and
the behaviour of markets, Fed Chairman Alan Greenspan puts it
succinctly when he "argues for supervisory and regulatory policies
that are more "incentive-compatible", in the sense that they are
reinforced by market discipline and the profit-maximizing
incentives of bank owners and managers."
Let the market work
- Given the growing complexity of banking business, and
derivatives activities in particular, there is now growing
consensus among regulators that a common, simple, static and
"one-size-fits-all" type of capital rules is inadequate. Rather,
banks themselves are in a better position to closely monitor their
own risk profile in a timely manner. Regulators should instead
assess and try to build on banks' own internal risk control models,
and encourage more disclosure for market assessment.
- As stated earlier, the risks of regulation are that the more
the state regulates, the more it underwrites the risks. Even worse,
the more badly the state supervises the system, the more it has to
pay. Avoidance of such moral hazard problems is thus extremely
essential. The Working Party report, for example, highlights the
modern supervisory approach of using market discipline and market
access channels. It recommends greater transparency through regular
and comprehensive disclosure of information. This information will
be efficiently used by such entities as rating agencies, credit
bureaus and central credit registers to provide incentives for the
adoption of sound supervisory systems, better corporate governance
and other key elements of a robust financial system. This is an
area where the accountants, auditors and professional financial
services have a vital role to play to help bankers manage their
risks more efficiently and transparently.
- Here I would like to mention the role of market infrastructure
in helping to improve market oversight. The functioning of a modern
real-time payment system is a discipline in itself. Real-time
delivery versus payment forces a bank to exercise greater
operational discipline and impose internal checks and balances in
the system. Failure to complete a transaction to settlement
immediately informs the market about the weakness of a participant.
The problem with old, manual systems is that too much "gapping" is
allowed. It is the inefficiency of the system that allows banks to
"gap" the maturity or the payment. However, such "gaps" imply huge
risks, and the larger the timing gap between settlement and
payment, the larger the credit and market risks experienced by the
participants. In other words, robust efficient market
infrastructure are themselves generators of sound market
information for the system to work well.
- Another important aspect of market discipline is to rely on
incentives tied to bank capital; to impose greater personal
liability for bank directors; to limit the disincentive effects of
explicit or implicit government guarantees and to encourage
voluntary market standards or guidelines. These measures directly
linked up one's self interest to the risks that he takes for the
institution in which he works. Self interests are better incentives
than external rules.
The Problem of Bureaucratic Inertia
- Let me now turn to an inherent problem of financial regulation,
which is sometimes called forbearance and otherwise called
bureaucratic inertia. It describes the case where even if the
regulatory framework is well set out, there runs a risk where
problems are delayed before resolution. Regulatory forbearance may
be due to a number of factors, including political and/or
supervisory interference, a lack of supervisory accountability, the
common "wait-and-see" attitude, or fears of legal challenge. In
addition, there comes to the more basic problems of the lack of
reliable information and the lack of qualified staff.
- As we all know, the costs of delaying corrective actions can be
very high. Weak and undercapitalized banks, if allowed to continue
their operation, may escalate the scale of losses. To address the
problem of regulatory forbearance, one possible means is to reduce
the discretion available to supervisors. The US, for example, have
adopted a more rule-based supervisory regime under the Federal
Deposit Insurance Corporation Improvement Act of 1991, where
particular corrective actions are mandated in accordance to the
different level of bank capitalization. However, some argue against
this practice, stressing the importance of supervisors' judgment in
detecting problems and taking corrective actions at the right
time.
- How do we deal with this problem at the domestic level is
clearly a matter for national authorities. But how do we deal with
this at the international level, since the contagion costs are
clearly rising in a global world?
- There is no easy answer, and I can only envisage that there
should be more dialogue between the multilateral forum and domestic
authorities on this issue. The implementation of information
disclosure is not something that one can be achieved overnight, so
that it is important that there be a period of phasing in
information disclosure, as with other areas of financial
liberalization. There should be greater discussion how
international institutions may help to promote the incentive
structure for the adoption of sound policies. Rating agencies, for
example, can help strengthen market discipline, as also the
proposals for an international rating classifications for financial
systems in different countries (Honohan, 1997). This is an area
where I keep an open mind and would like to hear different views on
how to proceed.
Checklist for Risk Management
- If we think through it more carefully, financial regulation is
essentially all about risk management. John Nugee, my former
colleague who currently manages foreign exchange reserves in the
Bank of England, used the acronym "ICAC" [the Hong Kong Independent
Commission against Corruption] to describes the evolution of risk
control systems. He pointed out that most institutions tend to
initially Ignore the risks. But when they realize that risk exists
and must be recognized, they Calculate it and are usually shocked
by the size of risk involved. Nevertheless, management should
realize and accept that their objectives are not to Avoid but to
Control risks, as higher returns are always associated with higher
risks.
- Earlier this year, the Bank of Japan has introduced a new set
of checklist for risk management. This new checklist emphasizes the
actual control of risks involved in different operations and
addresses that different types of risks may occur in a single
operation. In a way, the distribution of risks are clearly shown
and any risk concentration can be immediately identified. The
checklist is reproduced in the Annex.
- The Checklist approach is good for sectoral risk management,
but that is not the end of the story. There is a need for us to
take a broader view and look at risk management not only from the
sectoral level, but also from the national perspective.
Towards National Risk Management
- As a result of the large losses of banking system, the problem
of moral hazard [whereby the private sector gains at public cost]
has become a major issue. The greater the regulatory coverage, the
greater the risks of moral hazard, since the public assumes, not
without reason, that the purpose of regulation is protection.
However, excessive protection ends up paying the market price of
inefficiency and bailout costs. In other words, hedging techniques
often pass the risks between sectors [such as public underwriting
of deposit insurance], but does not avoid the risks of bank failure
at all and may under some circumstances add to the risks of
failure. Consequently, increasingly in the 1980s, there emerged the
awareness that financial sector regulation was all about national
risk management.
- This is because optimal policies at the sectoral level may not
be consistent with each other and the resulting net position may
not be optimal when the nation is considered as a single entity. At
the national level, there must be a coordinator to synchronize risk
management approaches of different sectors; to take an overview of
the national risk profile and to manage risks for the good of the
whole economy.
- Just as corporations controls firm risk based on
asset-liability management, a policy maker should apply national
asset-liability management techniques, using a national balance
sheet approach. Some general national risk management rules include
(Sheng and Yoon, 1993):
- fostering price stability to reduce system-wide risks and
uncertainties for private sector initiatives; fiscal discipline is
a key anchor of price stability;
- asset diversification: to broaden the production and export
structure to ensure competitiveness at international levels; and to
build up foreign exchange reserves when the domestic asset base is
highly concentrated;
- liability management: reduce national and sectoral leverage by
strengthening the capital base of corporations and banks; deepen
domestic financial markets; improve debt management and avoid large
maturity, interest rate and exchange rate mismatches;
- develop institutional and administrative capacity to assess
risk and to contain systemic risk;
- sequence financial sector liberalization measures with a clear
understanding of the risks involved, and with appropriate
institutional strength and fiscal resources to manage the
transitional process without losing macroeconomic stability.
- These principles of economy-wide risk management were applied
in Hong Kong, where supervisory coordination is achieved by close
liaison between the banking, securities and insurance regulators,
who all report to the Financial Secretary. In order to alleviate
the concentration risks of mortgage lending in banks, the Hong Kong
Mortgage Corporation was created this year, which will extend the
maturity profile of banks, improve the liquidity of mortgages and
help spread the property risks to long-term holders outside the
banking community. To improve market transparency and reduce
payment and settlement risks, a modern, streamlined real-time gross
settlement (RTGS) payment system became operational in Hong Kong in
December last year. This would enable financial market participants
to minimize huge settlement risks by being able to practice
Delivery versus Payment, and Payment versus Payment.
- Global financial markets are still at the stage of transition.
Many economies have not yet totally abandoned exchange control,
since their currencies and markets are still not fully liberalized.
Consequently, policies and practices at the micro and macro-level
very often assume that the degrees of freedom still exist as in a
closed economy model. On the other hand, the pace of liberalization
has gone far enough in many economies for them to have lost the
ability to control all the key economic variables at the same time.
It is therefore not surprising that policy outcomes are quite
different in the new open market environment.
- In that sense, the market discipline is already operating on
domestic economies and financial systems. Those systems that
function well will be rewarded by capital inflows, while those that
have inefficiencies ultimately face the prospects and pain of
potential capital outflows. We are certainly not in Kansas
anymore.