Regulators and financial intermediation

inSight

06 Mar 2003

Regulators and financial intermediation

Financial intermediaries play an essential role in any financial system. Their private interests, however, may not always be in perfect alignment with the public interest.

Financial regulators have occasionally found it difficult to balance the private interests of financial intermediaries and the public interest of promoting the stability, integrity, diversity and efficiency of financial intermediation. Given the importance of financial intermediation to economic growth and development, it is tempting to argue simply that the private interests of financial intermediaries, whenever they conflict or undermine the public interest concerning the process of financial intermediation, as described above, should be of secondary importance. But the viability of financial intermediaries does have a bearing on the smoothness with which savings are channelled into productive investments for promoting the economic well-being of the community. Failures of financial intermediaries can lead to costly disruptions. To that extent, regulatory forbearance is sometimes practised and the associated moral hazard tolerated, particularly when there is no effective safety net to protect the small savers and investors who are not able to protect themselves.

I have no doubt, however, that there should be free competition among financial intermediaries within a particular channel of financial intermediation and across different channels. Free competition pushes down the costs of intermediating funds and enables those with surplus funds to achieve a higher rate of return and those who are in need of funds to acquire them at a lower cost. This has been the effect of interest rate liberalisation through the phased removal of the Interest Rate Rules of the Hong Kong Association of Banks, which has contributed to a narrowing of the interest rate margin of the banks and greater cost efficiency. This reduction in the cost of financial intermediation through the banking channel has been manifested most obviously in the mortgage market, where, over a period of about four years, the mortgage rate relative to prime has come down by about four percentage points.

What financial regulators should try their best to guard against is the situation in which free competition and the economies of scale interact to increase market concentration, to the extent of encouraging non-competitive behaviour. But it is extremely difficult to identify such a situation, let alone pre-empt it. As a result, market concentration inevitably develops, even in the largest of financial markets, and once such a situation develops it becomes entrenched, and possibly reinforced by the political influence that comes along with the concentration of market power, and it becomes impossible to dismantle. This is reality and financial regulators cannot ignore it, however politically independent and well motivated they may be. And thus we have the less ideal but familiar situation across the world of financial regulators having to engage in the less transparent practice of moral suasion and "work closely" with the financial intermediaries.

Financial regulators also have the responsibility to emphasise repeatedly the primary function of financial markets in intermediating funds, lest this be forgotten. In the equity channel for financial intermediation, for example, where activity in the secondary market far overshadows that in the primary market, the primary purpose of the market in channelling savings into investment can often be ignored, or even forgotten. Given that the equity market is typically run with a high degree of self-regulation, there is always the danger of the private interests of the financial intermediaries running the market prevailing over the public interest. We have seen examples of such a danger resulting in severe market dislocation, hurting investors and undermining the effectiveness of such an important channel of financial intermediation, ultimately requiring corrective actions by the authorities, or by the financial intermediaries at the "suggestion" of the authorities.

Making the life of the financial regulators even more difficult is the globalisation of financial intermediation. This is particularly so for those overseeing financial markets that are big enough to attract international capital but not big enough to absorb comfortably the volatility that comes along. They have to deal with a significantly higher probability of misalignment between the private interests of financial intermediaries (including the international players with strong muscles) and the domestic public interest of ensuring effectiveness in financial intermediation. That is probably why the incidence of financial dislocation in those jurisdictions has been a lot higher.

 

Joseph Yam

6 March 2003

 

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