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,
- 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.
- 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.
- 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
- 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.
- 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.
- 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.
- 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 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?
- 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, 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.
- 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.
- 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
- 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, as all accountants
here know.
- 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.
- 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
- 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 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.
- 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
- 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.
Conclusion
- 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.
- 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.
- 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.
- Thank you.