Competition must be balanced by appropriate regulation and risk management.
As the freest economy in the world1, we in Hong Kong are familiar with the benefits of free markets, particularly in promoting economic efficiency. But we also know, very much through learning from experience, that we should be pragmatic in our support for free markets. Free markets can fail, and may help create monopolies and oligopolies making the allocation and use of scarce resources less efficient. So sometimes there is a need for government regulation to safeguard the public interest and protect the general public from possible exploitation. Free markets can also be manipulated by small groups of influential players. Our financial markets were subject to such manipulation in the Asian financial crisis of 1997-98, necessitating government intervention to put them back on track and protect the public interest. The financial system of the United States has been under excessive influence from financial intermediaries seeking to promote their private interests, an objective that is understandable in itself, to the extent of eroding credit standards and causing structural weaknesses, eventually requiring massive government intervention to put things right. But there is no doubt that the invisible hand of the free market, generally speaking, is far better than bureaucrats at directing the use of economic resources to promote economic welfare.
Similar arguments can be made to support free competition, which is considered the best way to achieve progress. But we are also aware that the benefits of free competition are not absolute. We sometimes come across "unbridled" or "cut-throat" competition, necessitating government regulation to protect or promote the public interest. But it is often not easy to be sure when government regulations are needed or what form or degree of regulation is best. What is considered appropriate at a particular time can change along with the expectations of the community or as a result of high-profile events adversely affecting the interests of all or part of the community. Hopefully the events of the recent global financial crisis will not cause the pendulum to swing too far back in the direction of limiting competition.
Take banking as an example. Despite the views of some proponents of free and competitive banking, there is a clear need for regulation of banking business and the prudential supervision of banks because they take deposits from members of the community many of whom may not be able to assess the credit risk of the banks. While we have the responsibility for supervising banks, we, and I believe the community, support competition because it will, on balance, benefit the depositors and the borrowers by enabling them to earn higher interest and borrow at cheaper rates. In other words, it leads to greater efficiency in financial intermediation and better support for the economy.
In the early days, possibly out of concern about excessive competition that might erode the robustness of the banking system and against the background of the banking crises in the sixties and the eighties, the law did allow certain arrangements among banks that inhibited competition, notably the Interest Rate Rules of the Hong Kong Association of Banks. But as the HKMA continued to strengthen the banking system through a number of banking reforms, including refinements to the supervision of banks, we were able in the nineties to gradually eliminate the Rules, allowing licensed banks to compete for deposits freely. This led to profound changes in the efficiency of banking in Hong Kong: the interest-rate spreads between deposits and loans have narrowed significantly. For example, residential mortgage rates (with reference to the Prime Rate) have fallen by five percentage points, from around Prime + 2% to Prime - 3%, in recent years.
But we must be alert to the possibility of competition causing banks to disregard prudent risk-management standards or branch out from traditional banking activities, of which they know the risks, into other existing or new financial services, whose risks they may be unfamiliar with. Competition and innovation, within appropriate bounds, are a force for good. But unrestrained competition and innovation can be a potently destructive mix, as we have seen all too clearly lately, and must be balanced by strong standards, appropriately aligned incentives and robust risk management by both the banks and regulators.
Joseph Yam
23 July 2009
1 The latest Index of Economic Freedom study released by the Heritage Foundation in January 2009 ranked Hong Kong as the world freest economy for the 15th consecutive year.
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