Prudent risk assessment and management are as essential as healthy competition for efficient financial markets.
Every now and then we hear complaints by dealers in the foreign exchange and money markets about the lack of volatility limiting the opportunity for them to make decent profits. Some have, for example, attributed recent quietness in those markets to the three refinements to the operation of the Linked Exchange Rate system introduced on 18 May 2005. There may be something in this. Indeed, notwithstanding the wider scope – a thousand pips in all – within which the exchange rate can now fluctuate, it has remained remarkably stable since the three refinements were introduced. Hong Kong dollar interest rates have also been tracking closely those of the US dollar, fluctuating within narrow ranges. Generating trading profits is always more difficult in a stable market. But currency stability, defined very clearly in the monetary policy objective determined by the Financial Secretary as a stable exchange rate, is obviously in the wider public interest, which must prevail.
This "conflict" between the private interests of market practitioners in making profits out of market volatility and the public interest in monetary and financial stability has been in existence as long as there have been financial markets. These markets play the very important role of bringing together those who have surplus money and those who are raising money for production, consumption, investment and external trade. Because of the differences between the appetite for risk of savers and the risk profile of borrowers, in terms of credit and liquidity for example, we need financial intermediaries to act as financial engineers to transform risks, make markets, provide liquidity and so on. Bankers channel money from depositors, who have a low appetite for risk, and assume risks by lending money to those that they, using their professional judgement, think are creditworthy, and of course in the process make a turn. Stock brokers make a market in shares and provide the secondary market liquidity necessary to entice investors and fund raisers into the primary market of initial public offerings, thereby serving the public interest by providing financial intermediation that promotes economic growth and development. For these services, the financial intermediaries, whether they are individuals or institutions, should of course be entitled to remuneration that is commensurate with their expertise, responsibilities and authority. But it is difficult to judge what levels of remuneration are appropriate.
It is not easy to strike a balance. To a large extent we can rely on the market, assuming a high degree of freedom of entry for those wishing to become financial intermediaries. This may sound unrealistic from a regulatory point of view. There is a need to ensure that financial institutions are prudently run. This necessity is often translated into entry restrictions or minimum qualifications for registered or licensed financial intermediaries. This may have the undesirable effect of creating a "captive" market in which financial intermediaries, being motivated always by the desire to maximise profits, enjoy remuneration that may be considered excessive. But, subject to prudential considerations, overseas financial institutions may be allowed access to the domestic market as financial intermediaries. This is generally the case in Hong Kong and is one contributor to the renowned efficiency, specifically of the banking system of Hong Kong. Indeed, encouraged also by the deregulation of interest rates, the net interest margin of banks in Hong Kong is now only 1.63%. Depositors are getting more than they would otherwise have done for their deposits and borrowers, for example home buyers, are paying less for their loans. This efficiency was achieved without any erosion of credit quality. Competition has not compromised prudence. But it is obviously something that we should all be alert to. Pressure to perform under intense competition, at both the institutional and the employee levels, encourages risk taking, which could eventually undermine the stability of the financial system, the confidence of those using it and the public interest in effective financial intermediation.
Joseph Yam
29 September 2005
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