Regulatory Structure, Market Oversight and Credit Agencies

Speeches

01 Oct 1995

Regulatory Structure, Market Oversight and Credit Agencies

Andrew Sheng, Deputy Chief Executive, Hong Kong Monetary Authority

(Speech at International Business Leaders' Advisory Council, Portman Shangrila Hotel, Shanghai)

Mr. Chairman, Distinguished Guests, Ladies and Gentlemen,

  1. I am very honoured to be invited today to discuss the issues of regulatory structure, market oversight and credit agencies in the development of Shanghai as a first class financial centre. These issues lie at the heart of the challenge of the transition of the central credit allocation system under a planned economy into a strong and robust financial system where the market has a major role in resource allocation.
  2. I shall not try to re-invent the wheel and simply quote from Gerry Corrigan1, the former President of the New York Fed and Chairman of the Basle Committee on Banking Supervision on what are the major characteristics of an open and competitive financial system:
    • The presence of a strong and appropriately independent central bank;
    • Broadly distributed private ownership of banks and other major financial institutions;
    • The absence of internal or external credit controls;
    • Market driven interest rates for both deposits and loans;
    • A unified foreign exchange system, where the exchange rate mechanism itself can be fixed, floating or something in between;
    • The presence of efficient and effective local capital markets;
    • Efficient, safe and trusted payment, delivery and settlement infrastructure with finality;
    • National treatment for foreign and domestic institutions;
    • Transparency in all things, including market practices; and
    • A strong but flexible system of prudential supervision of markets and institutions.
  3. Of course, not many financial markets in the world can claim to have a perfect "10" in this scorecard, but it is important to bear these characteristics in mind when creating a strong financial system. You will also notice that three out of the 10 characteristics focus on the need for a strong central bank, transparency and strong but flexible system of prudential supervision of markets and institutions, which is the scope of this paper.

Regulatory Structure

  1. The subject of regulation of financial markets and institutions is a big topic that deserves more time available than a simple overview. Because all financial products are essentially legal contracts, the shape of financial markets are determined by the legal and regulatory framework. There is, to borrow George Soros' concept, reflexivity between markets and the law. The law shapes markets and the markets shape the law. And since the law involves public policy, it is useful to summarize the key objectives of public policy in the regulation of the financial sectors. These include:-
    • Monetary stability
    • Efficient allocation of resources/national savings
    • Protection of consumers/domestic savings
    • Fair competition and trading
    • Prevention of fraud and criminal practices
    • Systemic stability
  2. Once the objectives are clarified, then there are structural issues to be dealt with. These include:-
    • Scope of business powers - licensing market entry, defining the types of permissible products or types of business, or even geographical limitations;
    • Regulatory coverage, by functional regulation or by institution. This includes potential overlap of laws and therefore overlap by regulator.
    • Consolidated or non-consolidated regulation of holding companies and subsidiaries
    • Market price and quantity controls, such as capital adequacy ratios, liquidity ratios, interest rate ceilings or floors, direction of credit, etc.;
    • Ownership and 'fit and proper' person considerations, such as private or public ownership, foreign ownership, and qualification of owners or staff;
    • Access to special facilities, such as lender of last resort, deposit insurance, tax privileges etc.
  3. The basic objectives of oversight of capital markets are no different from that for banking systems: the primary objective is efficient and sound resource allocation. However, there is now considerable overlap between different regulators because of the merging of markets. For example, many licensed banks now engage in securities business. Insurance companies are also very large fund managers and compete with banks in providing direct credit to non-bank borrowers. Fund managers in the United States, for example, offer credit card and money market funds that compete with the banks. As the finance business begins to merge, the regulatory framework also begins to overlap, not only functionally, but also geographically. Thus, the regulatory framework may not only clash in terms of institutions, but also differences between the local or provincial levels, the local/national levels and also international levels.
  4. The financial system may be divided into the following sectors, each with its own set of regulators (see Table 1).

Table 1: Financial Institutions and the Regulatory Structure

Institution Regulator Hong Kong United States
Deposit-taking Central Bank HKMA Various bodies
Banks " " Fed, OCC, FDIC, State Banking superintendents
Finance Companies " " Office of Thrift Supervision
Credit co-operatives Usually under another ministry Not applicable State level supervision
Mutual funds/asset managers Securities Commission Securities & Futures Commission Securities & Exchange Commission
Investment banking Overlap HKMA/SFC SEC
Debt markets Overlap HKMA/SFC SEC
Insurance Companies Insurance Commission Commissioner of Insurance State level commissioners
Securities houses Securities Commission SFC
Provident/Pension funds Various bodies Secretary for Financial Services/Proposed MPF Authority Department of Labor/Pension Benefit Guarantee Corp.
Futures & Options Futures Authority SFC Commodities and Futures Trading Commission(CFTC)/SEC

Techniques of Market Regulation

  1. Although financial sector regulation may vary across different industries, the tools of regulation and oversight are basically the same. Each regulatory authority would apply capital and liquidity requirements, prudential limits on exposures, risk concentrations and prohibitions and would have regular reporting requirements. To prevent excessive competition or entry of persons with inadequate capital, professional expertise or ethical standards, licensing and 'fit and proper person' tests may be applied. Thus, there are usually reporting and sometimes approval requirements to ensure that adequate disclosure is made, and that changes in ownership, expansion in business through branches, subsidiaries or affiliates have complied with the law.
  2. In the past, there was greater reliance on self-regulation. Today, there is world wide acceptance of the need for off-site surveillance, as well as examination and auditing. This requires both the use of good monitoring techniques, such as asset-liability and performance ratios, together with well-trained teams of examiners to detect non-compliance trends or practices. Increasingly, many regulators rely not on the internal risk management techniques of financial institutions and their external auditors. Some legislation require auditors to report the existence of fraud. Other regulators have regular tri-partite (firm, auditor and examiner) discussions on audit findings.
  3. The audit and examination function becomes even more crucial when there are implicit or explicit deposit insurance schemes in place. Any form of lender of last resort or government support in underwriting some risks in the financial sector would require adequate examination of the risks undertaken, to ensure that moral hazard does not worsen the costs for the public sector.
  4. There is one aspect of market regulation that does not always warrant the attention it deserves, namely, the orderly exit of failed or problematic firms. The regulations must have mechanisms in place to deal with troubled financial institutions, with clear guidelines on receivership, mergers, take-overs, bankruptcy or liquidation. Financial institutions are quite different from non-financial enterprises, in the contagion effect arising from their failure. Hence, adequate bankruptcy laws must also be put in place for these institutions, which may have to be placed in the financial laws, rather than the Company Law.
  5. The international experience, including that of Hong Kong, is that financial markets work well where there is a firm legal and prudential framework that protects property rights, and market participants from unfair practices. This calls for not only a good set of contract, commercial, banking and land laws and regulations, that are accepted by all market participants as open, fair and equitable, but also a court and arbitration system that will enforce contracts firmly and fairly. Hong Kong has all these laws - the Common Law - and systems in place, which have made domestic and foreign market participants - investors, issuers, intermediaries and the general public - confident that contract disputes will be dealt with fairly and expeditiously, while illegal and unfair practices would be punished according to the law. This set of laws is well understood and accepted by all international market participants.
  6. Hong Kong applies the highest international prudential standards in ensuring that all financial market participants can trade in Hong Kong under protection of the law, without fear or favour. We have struck a clear balance between the need for prudential regulation without stifling the innovative and entrepreneurial spirit of the market place. It is particularly important that the regulatory bodies are strong professionally and are able to exercise their enforcement action without any market perception of interference from any quarter. I am reminded of the excellent regulatory philosophy expounded by Mr Goh Keng Swee, former Finance Minister of Singapore, who paraphrased the Chinese philosopher Lao Tze in saying that "the regulation of banks should be like frying small fish - it must not be overdone". Of, course, Lao Tse would also advocate moderation in all things - regulation cannot be underdone. The enforcement action must be quick, firm and not only be fair, but seen to be fair.
  7. There is an inherent weakness in the regulatory framework in that the regulators are always accused of being one step behind the market. This is not surprising because the market thrives on cost arbitrage, information arbitrage, tax arbitrage and of course, regulatory arbitrage. The lag in the knowledge curve is quite evident in the derivatives market. I believe that the only way to solve this is for the regulators to keep an open mind and channel of communication with the market. In Hong Kong, we have a continual process of market consultation, both formal and informal, between the market participants and the regulatory authorities to ensure that the regulatory framework is responsive to changes in the market place, without sacrificing the need to protect the public interest.
  8. The experience from Hong Kong is that if you maintain a market-friendly policy environment, the markets can evolve quite quickly on their own account, without the need for subsidies or government intervention. A level playing field is not just equal treatment before the law, but the level matching of risks versus rewards. With a clear level playing field, an equitable and credible tax and regulatory regime, the financial markets will respond to the growth opportunities in the environment.
  9. Hong Kong operates one of the freest financial centres in the world, with low tax, no exchange controls and a level of regulation generally on par with the developed markets. The philosophy of regulation is one of "caveat emptor" - buyer beware, and except for more rigorous oversight with respect to small retail investors, the larger and more sophisticated investors, defined as those who can afford to buy a financial instrument worth more than HK$1 million (US$130,000), are expected to be sophisticated enough to look after their own money. By and large, most of the debt and derivative markets, which are OTC in nature, are self regulated, but with an overview by various authorities. The equity, mutual funds and futures markets are supervised by the Securities and Futures Commission (SFC), with most of the stock market activities self-regulated by the Stock Exchange of Hong Kong (SEHK). In terms of supervision of financial intermediaries, securities dealers are registered with the SFC, while exempt dealers, usually the subsidiaries of authorized banks, restricted-license banks and licensed deposit taking companies, are supervised by the Hong Kong Monetary Authority.

Rating Agencies

  1. Markets thrive on information. They are both a digester of information, and at the same time, a provider of information. There is an increasing trend of regulation that if the regulator or the public does not understand what is happening, it is better that there is full disclosure of information. A clear set of market regulations, include code of conduct and best practices, that is openly available for all market participants is not only helpful but essential for market development. The recent arrival of credit rating agencies has raised their profile in Asia. What is their role in the development of markets?
  2. Credit rating agencies arose in the United States in the nineteenth century to assist the rating of bonds. Today, they have become international and the largest of them may rate as much as US$5 trillion of paper. Their market power is clearly obvious. A number of them have recently set up shop in Asia, following the arrival of the global investment houses. Because the international rating agencies are largely private sector, they can be seen as private sector mechanisms to regulate the market. In some countries, for example, India, Malaysia and Thailand, the government has taken the initiative to create government owned rating agencies.
  3. The public sector regulators use the rating agencies for two major purposes: for defining investment grade paper (and therefore eligibility or prohibition of investment for regulatory purposes) or for the calculation of capital charges. This confers on the rating agencies further market power, since an upgrade or downgrade of rating immediately affects not only the cost of funds, but also the accessibility to investment by pension funds, banks and other financial institutions. Since there is an incentive for the rating agencies to gather information to conduct their ratings, they help the regulators to formulate their market oversight, without having to devote substantial resources to gather that information.
  4. Hitherto, regulators outside the US have not paid much attention to whether there should be a franchise given to rating agencies. The Securities and Exchange Commission has so far approved only four rating agencies as Nationally Recognized Statistical Rating Organizations (NRSROs). Rating agencies do not generate controversy in the area of solicited ratings, because an issuer voluntarily sought a rating and willingly co-operated with the provision of information. Where there is more heat and light is the question of unsolicited ratings. Well capitalized and managed institutions in Asia suddenly wake up one day to find that they have been rated 'vulnerable' by a rating agency. It is not surprising that some people feel that the market power of rating agencies have reached the stage where they can effectively say "I don't know you, you're in trouble!".
  5. As the Queen said in Alice in Wonderland, your point of view depends on where you stand. I personally do sympathize with those unrated institutions who have been given what they considered unwarranted or unsolicited ratings by the international rating agencies. At the same time, the rating agencies feel justifiably that the market now demands more information from the major issuers or players in the global financial world. Of course, competition and market arbitrage will proceed to the extent that there is more and more ratings arbitrage, shopping for where the ratings are more friendly. This poses very difficult questions for regulators to "rate the rating agencies".
  6. My personal opinion is that since we live in an interdependent world, there is increasing need for greater disclosure for market participants, from firms to sovereign economies. At the same time, there is also greater need for the rating agencies to be more transparent in their ratings methodology. While it is easier to accept quantitative measures of market performance, it is much more debatable how the final rating is arrived at with what the rating agencies themselves admit is a black box that is "very heavily qualitative and judgement-driven".
  7. It is however a market reality that the rating agencies are here to stay. They are part of the market-driven process of information gathering and processing, and whether their judgement is right or wrong, the market will eventually decide.
  8. I hope these thoughts are useful to the development of the financial market in Shanghai.
Latest Speeches
Last revision date : 01 October 1995