Risk management in financial markets

inSight

08 Feb 2007

Risk management in financial markets

Recent developments in financial markets have increased levels of risk.

It is human nature that, when things are going well, people tend to get carried away to the extent of taking decisions impulsively: financial matters being no exception. Some people even choose to embrace a "make or break" attitude, leaving things to sheer luck, when things are going really well. After all, opportunities like the stock market gaining 500 points in one day do not come along often. Because of this human nature, economic units are often more likely, when the economy is buoyant, to assume risks that they are actually not able to manage. This is one of two observations to which I have been trying to draw attention, in the hope of encouraging prudent risk management, and perhaps also proper pricing of risks in the financial markets.

My other observation is something everyone can see but many of us prefer to ignore. Given the current abundance of liquidity, there is a risk that volatility in the major financial markets may increase sharply and suddenly. And the characteristics of the financial markets of Hong Kong make them prone to even greater volatility. Some of the financial instruments traded in Hong Kong are issued by or derived from entities operating in an economic environment that is still much less market-oriented than others. The telescoping effect of Hong Kong's free market by which any shifts in the outlook for the Mainland, whether or not arising from the continuing macro adjustment and control, are translated into movements in spot prices should not be underestimated.

My observations are of general relevance, but perhaps more so for emerging markets. When the above scenarios interact with each other among individual markets they are likely to produce outcomes that we all, particularly those responsible for financial stability, should be alert to. There are three possible outcomes. The first is that the authorities become so concerned about imprudent risk taking and sharp financial market volatility that they introduce policy changes aimed at dampening volatility and therefore vulnerability to financial instability. This is quite legitimate given that financial stability is a very desirable policy objective. But managing policy changes is always difficult. Financial markets do not like surprises, so there is always the risk that the announcement of policy changes which are aimed to maintain financial stability may itself precipitate financial instability. And this may be contagious across domestic markets or across jurisdictions.

The second possible outcome is that those taking excessive risks, particularly economic entities that are significant for the stability of the system as a whole, might get hurt so seriously by volatility that not only is their own viability undermined but also that of the financial institutions dealing with them.

The third possible outcome is the best one, where the authorities are able to steer a steady course, fine-tuning where necessary within a policy framework that the financial market is familiar with, and where the inevitable failures of those taking excessive risks turn out to be isolated events of no systemic significance. This is the outcome that we would all like to see as we go through the economic and financial market cycles. This is also currently the most likely outcome, hopefully not just in Hong Kong but also in neighbouring economies.

But I fear that the probability of the first two less benign outcomes has been increasing. I have a duty to share this view with all those involved in the financial system of Hong Kong. I believe being aware of the risk is a very good start to managing it, particularly for financial intermediaries, whether as a creditor or a party in a transaction. I see this as an important ingredient in the maintenance of financial stability and the sustainability of financial soundness and economic progress.

Joseph Yam
8 February 2007

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