A deep-rooted dilemma

inSight

09 Mar 2006

A deep-rooted dilemma

How to resolve the conflict between public and sectoral interests is a persistent problem for policy-makers, particularly in the financial field.

Premier Wen coined the phrase "deep-rooted dilemma" some time ago in commenting on Hong Kong. The phrase has since become quite popular in describing situations in which there are conflicting objectives but no obvious or suitable solutions. I have found the phrase particularly appropriate in describing the situation often faced by policy-makers having responsibility for a financial system. This is a situation in which there is conflict between the public interest in ensuring effective financial intermediation that promotes the general well-being of the community, and the private interest of financial intermediaries in maximising profits.

The principal role of the financial system in any economy is to channel funds from those who have a surplus to those who are short of money. Because the risk of lending to people who might not be able to repay might be larger than the risk willingly assumed by those with money to save, there is a need for financial intermediaries. Different types of financial intermediaries play different roles to cater for the needs of different categories of savers (or investors) and fund raisers. In the simple case of the banks, they take money from savers on deposit, promising to repay the money on demand or at maturity of the deposit, depending on the deposit arrangement, and lend the money on to borrowers. The depositors are exposed to the credit risk of the banks, in other words the ability of the banks to repay the deposit, and the banks are exposed separately to the credit risk of the borrowers. In acting as middleman the banks assume risks, and, rightly, are remunerated for it. The remuneration takes the form of the net interest margin, that is, at the risk of over simplifying it, the net difference between the deposit interest rates and the lending interest rates. In the more complicated cases of the debt and equity markets, where the investors actually take on the risk of the fund raisers, the roles of the financial intermediaries include the creation of the financial instruments in the primary markets (the Stock Exchange and the underwriters of new share issues) and the brokering of transactions in these instruments in the secondary markets (the brokers and the market makers).

An effective financial system is one that gives a high rate of return to those saving or investing money, and a low cost of funds for those raising money. But clearly for the intermediaries to play their specialised role effectively, they need to have the correct incentive to do so, and this means a reasonable level of remuneration for them, in terms of profits for the financial institutions and pay for those working in them. To ensure reasonableness, policy-makers often, and rightly, rely on the competitive forces of the market. But this is not always possible, at least not to the fullest extent, because the specialised role of the intermediaries, in handling other people's money, can only be performed by those with a high degree of integrity. This means there is a need for appropriate entry or licensing criteria, a degree of supervision of the activities of the intermediaries, and market regulation. This also means a somewhat protected mandate for the intermediaries that may be strengthened by the existence of industry associations, which pursue vigorously their private, profit-maximising interests, among other things. The more successful the intermediaries are in their business (and as in all businesses success is measured by the profits they make), one can argue, the less effective is the financial system in financial intermediation.

This then is the deep-rooted dilemma often faced by policy-makers. There is no solution that pleases everybody. Often the intermediaries, being well organised, perhaps even at the political level, have quite a strong voice. This is not to say that the intermediaries pay no attention to the public interest at all. Some will agree with the policy-makers that, in the long run, the private interest of profit maximisation by the financial intermediaries and the public interest of effective financial intermediation should converge. But, realistically, achieving the short-term profit forecast is always a very high priority for the intermediaries.

This deep-rooted dilemma is likely to resurface in the in-tray of the policy-makers, if it is not there already, as information technology leads to a fundamental change in the mechanism for delivering services from financial intermediaries. Just imagine the stock market as a totally computerised trading and custodian system linked with the electronic money payment and settlement system, so that real-time delivery versus payment happens instantaneously when a transaction is made, even at the retail level. This market structure, being the most robust and desirable from the risk management and efficiency points of view is technically possible now, and should be considered as the target for market development. But then one would ask the question: what would be the role of the intermediaries?

 

Joseph Yam

9 March 2006

 

 

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