The lessons for emerging markets may be different from those for developed economies.
There has been no lack of views about what lessons should be learned from the continuing problems in global financial markets. These have come from the affected jurisdictions and from international financial institutions and forums. The views expressed so far have been insightful and sometimes quite complex but, understandably, they have mainly been from the perspectives of the developed markets.
The main focus of these views has been what was not sufficiently understood in the run-up to the problems that emerged in the third quarter of last year, and whether the responses by the international community have been adequate and appropriate. From the perspective of the emerging markets, I think the emphasis is rather different, in part because the emerging markets were somewhat behind the developed ones in the kind of financial innovation that gave rise to the problems – fortunately as it turned out. Rather more relevant to them I suspect are how best to tackle financial innovation and, possibly for those with less open financial markets, how best to programme financial liberalisation.
I certainly hope that the current turbulence in the developed markets – which is the result of financial innovation getting out of control – does not result in an indiscriminate shunning of financial innovation generally, although I fear that it has, arguably, provided emerging markets with a very bad example. Obviously financial innovation has to be properly harnessed, first by making sure that its benefits clearly take the form of more efficient financial intermediation (in other words, a lowering of the intermediation spread, rather than just serving the interests of financial intermediaries through large compensation packages for the financial engineers, which actually increase the intermediation spread) and secondly by prudently managing the risks arising from financial innovation.
Central banks and others responsible for financial stability should perhaps adopt a more pro-active attitude to financial innovation, through monitoring and perhaps even steering the process, and getting involved early on in identifying and managing the associated risks.
It is obviously difficult to keep up with investment bankers, who may also be a strong political lobby in some jurisdictions, but it is in the public interest that the authorities should at least try, if necessary making use of their authority to seek information, require public disclosure, or even to approve financial arrangements, moral hazard notwithstanding. The thing that must always be borne in mind is the overriding public interest in maintaining financial stability. We also need to be alert to the possibility of distortions to incentives in the financial system creeping in, leading to the erosion of credit standards, as happened with securitisation and credit-risk transfer through the originate-and-distribute model.
It is important to recognise the potential conflict between the public interest in efficient financial intermediation and the – perfectly legitimate from their point of view – private interests of the financial intermediaries in maximising profits. The market, regrettably, has so far not provided a solution to this conflict, at least not a solution that does not involve financial turmoil, with the apparent initial narrowing of the intermediation spread being inevitably followed by a sharp step increase, as we are seeing now. The authorities are more often than not left to deal with the problems arising from the conflict when problems set in. Some are more successful than others in pre-empting problems, for example by firmly, some say stubbornly, exercising supervisory authority to safeguard against the erosion of credit standards.
I therefore support the many initiatives by the international financial community that have been implemented or are being discussed, aimed at making the financial system more resilient. They are very comprehensive and, rightly, very focused. However, to what extent they can address the general issue of the conflict I mentioned being an inherently unstable factor in the financial system, often manifested in distortions to incentives that are sustained in the short term by arrangements that compromise prudential standards, only time will tell.
Joseph Yam
14 August 2008
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