Regulatory and Development Issues in the East Asian Region

Speeches

26 Aug 1997

Regulatory and Development Issues in the East Asian Region

Andrew Sheng, Deputy Chief Executive, Hong Kong Monetary Authority

(Speech at KPMG Asia Pacific Banking and Finance Conference and Training "Balancing Risk and Reward in the World’s Fastest Growing Market", Kuala Lumpur, Malaysia)

Mr Nicholas Etches, Ladies and Gentlemen,

  1. I am delighted to be back in Kuala Lumpur to be among old friends and new friends. When I left Kuala Lumpur just over eight years ago, I was still a regulator. Today, my work entails more the oversight of financial markets rather than banking supervision, since that is the job of my colleague, David Carse in Hong Kong. My former colleague, Dato' Murad Khalid, Assistant Governor, Bank Negara, is far more qualified than me in presenting an overview of regulatory issues.
  2. What I propose to do today is to give you an overview of recent work in the international community on maintaining financial market stability in a global, open environment. I refer specifically to two major initiatives, the Basle Committee's Core Principles and the Report of the Working Party on Financial Stability in Emerging Market Economies. Taken together, these two reports are some of the most important initiatives in addressing financial market regulation issues in recent years and are directly relevant to the currency turmoil that we have seen in Asia in recent months.
  3. Specifically, I shall make four basic points:-
    • First, in the new millennium, banking is undergoing a dramatic structural change as a result of technology, financial innovation, new competition and a global financial market. Financial regulation therefore must also become global in outlook. As Professor Charles Goodhart says, "Finance is rapidly becoming global; but laws and regulations are national."
    • Second, the stresses and strains in terms of global capital flows all end up in domestic financial markets, so that the domestic banks bear the brunt of adjustment. In this age of securitization and asset hedge, market participants act like herds with the classic problem of "fallacy of composition". Mismanagement at the corporate or bank level add up to national mistakes, that can add up to regional or international crises through contagion.
    • Third, 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.
    • Fourth, despite all its faults, the market does work. 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. In economic terms, this 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.

Brave new world, old-fashioned credit risks

  1. In the last two decades, the global financial system has witnessed dramatic changes that have brought about both higher risks and rewards. After being heavily involved in the restructuring of the Malaysian financial system in the mid-1980s, I was engaged in a survey of problem financial systems at the World Bank. At the end of the 1980s, 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.
  2. 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 trading 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.
  3. 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. Nowhere is this more evident than Malaysia, where the KLSE stock market capitalization is US$280 billion or roughly 2.8 times GDP. At the end of 1995, total funds under management by provident, insurance and mutual funds was nearly RM200 billion, just under half the size of the banking system.
  4. 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.
  5. 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.
  6. All these structural developments widen the boundaries of financial markets and add to increased competitive pressures, both functionally, domestically and internationally.
  7. I put this in a global context because, as the Americans 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. As Gerry Corrigan, former President of the New York Fed and Chairman of the Basle Committee liked to say, it was old fashioned credit risks that more often than not got a bank into trouble. On the other hand, financial innovation has meant that banks are increasing getting themselves also into trouble in the new world of derivatives on the liabilities side. 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?
  8. 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.
  9. 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.
  10. All the new rules of the game are being spelled out in the Basle Committee's 25 Core Principles, which are summarized in Annex 1. I do not intend to get into the nitty gritty of supervisory issues, but what I shall try to do is to sketch the framework how the global community is viewing the challenges facing the maintenance of Financial Stability in Emerging Markets. First of all, I want to stress that the principles surrounding financial stability are applicable to all economies, advanced or emerging, and one should not presume that only emerging countries suffer from banking distress. The fact that in the last 15 years, almost all OECD countries had minor to major banking losses means that no one is immune from the problems facing the global financial community. No one can be complacent, as the rapidity of how the market punished the slightest policy mistakes in Thailand and Mexico has shown.
  11. The Working Party Report on Financial Stability in Emerging Market Economies, which I participated in, involves a strategy for the formulation, adoption and implementation of sound principles and practices to strengthen financial principles. A summary is provided in Annex II and the full report is readily available on the Web (http://www.bis.org). Basically, the strategy involves three key principles:
    • first, the responsibility for financial stability rests with national [rather than international] authorities, since they have to foot the bill,
    • second, financial stability is achieved when international prudential standards are met, and when markets function well [ie competitively, professionally and transparently].
    • third, sound macroeconomic and structural policies are essential for financial system stability. In other words, no matter how complicated it has evolved, the financial sector is nonetheless a derivative of the real economy. To cure any problem in the financial sector would require a "bottom-up" approach. Take care of the fundamentals ie the underlying asset, and the financial markets [the derivatives] will take care of themselves.
  12. When asked recently by a journalist about how I felt about the Report, I replied half-seriously, "how can we question the Bible?" The Report contains extremely useful principles and lessons on financial stability which are well worth reading. I would simply like to add a commentary to some key facets which I feel deserve a bit more elaboration.

The Fallacy of Composition

  1. 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.
  2. 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, as all accountants here know.
  3. The "fallacy of composition" 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 goes hay-wire. 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. Thus, the market functions well when information about the micro and macro risks in the system are readily available to everyone.
  4. 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."

Towards National Risk Management

  1. 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.
  2. 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.
  3. 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 mismatch;
    • 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.
  4. 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.

Let the market work

  1. 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.
  2. 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.
  3. 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.
  4. 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.

Conclusion

  1. In an open and complex global financial market of 24 hour trading in real-time, all banking systems remain vulnerable to rapid changes in macroeconomic environment, policy framework and sharp swings in asset prices. We can no longer afford to be complacent. The global market is constantly searching for arbitrage possibilities, so that policy mistakes are punished quite quickly. We no longer have the time not to address these urgent structural and operational issues.
  2. Financial stability is a key requisite of strong and healthy economic growth. There is therefore great responsibility on national authorities to build stable, flexible and robust financial structures. This can only be done if the domestic financial institutions are well capitalized and well managed, and the financial infrastructure is sound.
  3. Central bankers may hedge their bets but they cannot hedge their responsibilities. Whether we like it or not, the challenge of a global financial market is already upon us. That is why there is considerable scope for greater cooperation between the private sector and the public sector, and between central banks around the world, to build a safer, sounder global financial market.
  4. Thank you.
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Last revision date : 26 August 1997