Central banking institutions have the duty to identify and assess risks to monetary and financial stability. Not only does awareness of risks put us in a better position to deal with them; it can also reduce their chance of materialising.
More on risk management, and let me go beyond the technical aspects of the risk-based capital adequacy requirement for banks and talk about the role of the financial authorities in risk identification and assessment. Financial authorities, particularly those with responsibility for monetary and financial stability, and the market regulation and prudential supervision in support of it, have an important duty to monitor the risks and vulnerabilities of the monetary and financial systems. They are in a special position to do so, for they have the authority to seek relevant information from market participants and to look first-hand at industry-wide trends. Furthermore, they are in a position to approach the matter more objectively, because they are not directly exposed to the risks (or the rewards) and they have a longer memory of past events and the lessons learned. They can also tap the experience of their peers in other jurisdictions. With the globalisation of financial markets and the highly contagious nature of financial crises, this experience is highly relevant. As a member of the international Financial Stability Forum, which has been meeting every six months or so since the financial crises of 1997-98, I can vouch for the usefulness of a dialogue on financial stability among financial authorities.
So, when the financial authorities with responsibility for the maintenance of monetary and financial stability express concern or caution, or issue a warning on something, they usually do so with good reason. Invariably this is associated with possible risks to monetary and financial stability they have identified. A good way of pre-empting those risks, however remote they may be in the eyes of those merrily enjoying and benefiting from the underlying developments, is simply to draw attention to them. When everybody - market participants and intermediaries - is aware of the risks, the likelihood of their materialising is often lowered, but perhaps at the expense of dampening market activity in the short term. The identification of risks in the monetary and financial systems is never too early, even though when they are successfully pre-empted in this manner those who drew attention to them are accused of crying wolf or spoiling the party. Believe me, such accusations are much to be preferred to being criticised for not blowing the whistle in time.
There is no doubt that monetary stability, particularly when it is so unambiguously defined as a stable exchange rate under currency board arrangements, has to be underpinned by healthy economic fundamentals, substantial reserves and prudent management of the public finances. Readers will recall that we in the HKMA were the first to point to the risks concerning the sustainability of the Linked Exchange Rate system arising from large budget deficits, high unemployment and deflation. The fact that this very potent combination of problems has not, in the past few years, undermined stability in the exchange rate can, at least partly, be attributed to the open discussions we have encouraged on those risks. These discussions were supported by rich and objective analysis not only from our organisation but also from the international financial institutions, the rating agencies and the private sector. They have been helpful in enhancing appreciation by all concerned about the severity of the economic problems and the adjustments necessary to resolve them, however painful they may be. The problems are still there, but so is a credible strategy to resolve them. Coupled with the impressive economic recovery - the product of going through painful but inevitable structural adjustment - the risks to monetary stability have thus been subsiding.
The identification and assessment of risks to banking stability invariably involve an understanding of the behaviour of markets to which the banks are exposed. While it is for the banks to conduct banking business and decide what assets to hold or what type of borrowers to lend to, I hope they do not mind receiving occasional, gentle reminders on historical facts and on their relative positions in relation to the industry average. Readers are aware of the recent reminder we issued on the market and interest rate risks of banks' holdings of debt securities. Indeed, apart from the mortgage portfolio, the risks of which are thankfully subsiding, debt securities are a significant chunk of bank assets. Interest rate hikes are on the horizon. It is only a question of when and how much. In my Viewpoint article on 1 January 2004 concerning the outlook for 2004 I drew attention to the possibility that these could be "larger and sooner than expected". I am of the view that the possibility is still there, although accommodative policies are being pursued by major economies. I sincerely hope that I am wrong about this possibility. But the important point is that the risks are identified early and prudently managed by all. Whether or not they materialise is of less significance. Stability through turning points that can possibly be sharp and destabilising is paramount.
Joseph Yam
25 March 2004
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