Diverse and efficient channels of financial intermediation help economies to cope better with financial crisis. Monetary Authorities have a role in helping these channels to develop.
A speech made by Alan Greenspan on 27 September 1999 is of particular interest to emerging markets. Drawing on the experience of the global financial crisis of 1997 and 1998, he pointed out one of the most important general principles in financial intermediation: the need for diversity and back-up facilities.
As usual, these words from someone who must now be one of the most influential men on earth are wise indeed. The process of financial intermediation is of crucial importance to any economy. It is a process through which an economy's savings are transformed into capital investment. If the process is efficiently organised, it boosts economic growth, with consequent improvements in the standard of living for the people. If instead, money is saved under mattresses and those wishing to invest lack funds, then economic development is seriously hampered. The question then is how to achieve and maintain efficiency in this important process.
The initial task must be to build the various channels of financial intermediation. Fortunately, market forces can usually be relied upon to perform that role by establishing the familiar channels of banking and capital markets, including those for debt and equity. The role of the monetary authorities is a largely supplementary, albeit important one. It focuses traditionally on the protection of depositors and investors, but usually only on the small ones who cannot always be expected to protect themselves. For this and other related purposes, financial markets are regulated and financial intermediaries are supervised.
But there is also a wider role for monetary authorities in the development of financial intermediation. Much though we might wish to leave markets to develop freely on their own by responding to the forces of supply and demand, there is a possibility that one among the channels of financial intermediation, together with its intermediaries, might become too dominant, while others remain persistently underdeveloped. Obviously, the important process of financial intermediation should not be overly dependent upon one channel or one group of intermediaries, who may be vulnerable to adverse developments of one kind or another. When a crisis occurs, as it inevitably will even with the best regulatory system in place, the hope is that there would be alternative channels for savings to continue to flow adequately into capital investment in order to sustain economic expansion.
Last year in the United States the banks served as an effective back-up for the capital markets, as the latter seized up following difficulties in funding leverage. A consortium of banks came to the rescue of LTCM and the economy continued to grow impressively. Earlier, in 1990, when it was the banks in the United States that seized up as a consequence of a collapse in the value of real estate collateral, the capital markets were able to substitute for the loss of bank intermediation.
Although the situation in Hong Kong is somewhat better than in many of the emerging markets around the globe, the degree of diversity seems inadequate. Our debt market, although more developed than those of many others in the region, is by no means an effective back-up for the banks. Indeed, when we experienced a seizing up of bank financial intermediation in the early eighties as a result of the collapse of the property market and the failure of a number of banks, our debt market did not really play a significant role as back-up. Funding for investments was hard to come by. Although, as a very external oriented economy, Hong Kong cannot escape worldwide economic trends, the impact on the economy generally and on the financial industry in particular could have been less severe if we had had a deep and liquid debt market as back-up.
The same happened in the financial crisis of the last two years. Asset prices, and thus the value of bank collateral, fell sharply. There was no banking crisis. But to prevent adverse effects on their financial viability, the banks understandably adopted, and are still adopting, a conservative lending strategy. The total amount of domestic loans for use in Hong Kong has been falling continuously for 16 months, causing hardship for borrowers, in particular for the small and medium-sized enterprises. This might have been one significant reason behind the rather sharp fall we saw in our gross domestic product.
Alan Greenspan puts it well: "diversity within the financial sector provides insurance against a financial problem turning into economy-wide distress". And, he adds, "steps to foster the development of capital markets in those economies should also have an especial urgency". Indeed, we need to intensify our efforts, which we began in early 1990, to develop the debt market in Hong Kong.
Joseph Yam
28 October 1999
More information on Debt Market Development can be found here.
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