A Basic Law of Finance

inSight

10 Aug 2006

A Basic Law of Finance

Some basic purposes of finance should always be kept in mind.

 

Finance is not a mysterious or esoteric subject, but it is often misunderstood. As prices of financial instruments go sharply up and down, and the opportunity for profit, multiplied through leverage and the use of derivative products, mesmerises all concerned and provides employment and income for many, the basic purpose of finance is often ignored or even forgotten. There is then a risk of finance taking on a life of its own, behaving in a manner inconsistent with the public interest. It is necessary, from time to time, for all concerned in finance to be reminded of the basic purpose of their existence. I have therefore put together a "Basic Law of Finance." This is purely an educational tool, and is not, of course, to be confused with the Basic Law of the Hong Kong Special Administrative Region of the People's Republic of China, which contains among its articles the basic policies on Hong Kong's financial and monetary systems.

Article 1
"Finance is very important; it is the nucleus of a modern economy." (Deng Xiaoping)

 

Article 2
Finance means financial intermediation. This is the process of channelling money from those who have a surplus of it to those who are in need of it, in other words, from investors to fund raisers.

 

Article 3
Effective financial intermediation is essential for promoting, maximising and sustaining economic growth and development.

 

Article 4
The preferred balance among risk, return and liquidity of individual investors differs, so do the credit-worthiness and profitability of fund raisers; the profiles of the two sides do not often match.

 

Article 5
The fundamental role of the financial system is financial intermediation, matching the needs of investors and fund raisers and, in the process, allowing risk to be shared and managed.

 

Article 6
A modern financial system consists of diversified channels of financial intermediation? the banking system, the debt market and the stock market. These three channels allow different degrees of risk-taking by the investors, different sources of funds for the fund raisers, and, typically but not only in the case of the banking system, risk-taking by the intermediaries as well.

 

Article 7
The private interests of financial intermediaries, who are understandably motivated by profit, are not necessarily aligned with the public interest of effective financial intermediation. Where there is conflict, it is the role of financial regulation and supervision to ensure that the public interest is protected.

 

Article 8
The effectiveness of the financial system is best achieved through a freely competitive and transparent market, but the systemic risks if anything goes wrong are high, necessitating the involvement of the authorities in the regulation of financial markets and the supervision of financial intermediaries, involving where necessary entry restrictions and special responsibilities for financial intermediaries.

 

Article 9
The involvement of the authorities in the financial system, through the regulation of financial markets and the supervision of financial intermediaries, should be aimed at promoting the stability, integrity, diversity and efficiency of the financial system. There should also be a special focus on providing a measure of protection for investors (including depositors), particularly the smaller ones.

 

Article 10
The major purposes of the secondary market in financial instruments are to provide liquidity so that the primary market, in which new or additional financial instruments are issued by fund raisers and subscribed by investors, maintains its attractiveness as a channel of financial intermediation, and to facilitate risk management. All concerned in the secondary market should bear these purposes in mind.

 

Article 11
Just as the physical infrastructure is important for ensuring the safe and efficient movement of people and goods, and therefore the proper functioning of the economy, the financial infrastructure is equally important for ensuring the safe and efficient movement of money, and therefore the proper functioning of the financial system and the economy.

 

Article 12
The financial infrastructure is a public good: it may not be possible or appropriate for certain elements of it to be provided through the market, for reasons of competitive fairness and commercial viability, and the involvement of the authorities in the development and operation of these elements is essential.

 

Article 13
An international financial centre is a centre where financial intermediation is conducted on an international dimension, which is frequented by foreign investors and foreign fund raisers, generating large flows of international funds, and which is characterised by the presence of foreign financial intermediaries. The existence of international financial centres helps promote growth and economic development in the regions that they serve.

 

Joseph Yam

10 August 2006

 

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Last revision date : 10 August 2006