The fundamental purpose of financial intermediation

inSight

04 Sep 2008

The fundamental purpose of financial intermediation

Simpler ways of bringing investors and fund-raisers together may be more cost-effective in the long run.

Readers may have noticed the many comments by members of the international financial community about the severity of the stress that has been plaguing the financial systems of the developed economies, in particular the United States. These have been echoed by the local financial community, as local financial institutions have taken successive hits on their holdings of structured financial products originating from the developed markets. It may be difficult for members of the public to appreciate the significance of all this, particularly when, apart from the large downward adjustment in stock prices they have seen, and may have suffered from, since the end of October last year, they have not been much affected. But for those of us watching the developments in global finance, in whatever capacity, what has been going on gives some cause for concern.

The severity of the financial stress is clearly demonstrated by the extent to which the authorities in the US have been willing to intervene, whether to ease financial-market tension, rescue systemically important financial institutions, or support the housing market. Those were unprecedented interventions, considering the traditional reliance in the US on market freedom. And, a year into the crisis (I think we can now call it a crisis without upsetting anyone), even the most progressive financial institutions are still saying that they cannot yet see the end of the tunnel.

I expect readers will understand that we in the HKMA, having some responsibility for financial stability, experience some unease when we see risk premiums jumping up and down; what used to be highly rated and liquid financial assets being sold at 22 cents on the dollar; and top-flight financial institutions losing billions and having to repeatedly raise more capital, not to mention the launching of the many controversial rescue operations. But obviously there are valuable lessons to be learnt and we are doing that, including going through the many reports (now about two feet high when printed on both sides of A4 paper) that have been prepared by international financial institutions and forums, ticking off those recommendations that already apply in Hong Kong (quite a number of them), reflecting on those that are relevant and acting on them where they can appropriately be applied.

And by the look of it, this crisis is likely to lead to changes in the structure of the financial system in the US that may have important implications for other jurisdictions. The financial system is supposed to match the risk appetite of investors with the risk profiles of fund raisers. The way that this has been done in the US has proven to be unstable and therefore unsustainable. That US "box" (which is used globally), into which investors put their funds (for a return) and from which fund raisers take what they need (for a price) to finance their activities, has turned out to be defective. What promised to be a highly efficient means of producing, in a largely free-market environment, the lowest spread between the return for the investors and the price for the fund raisers, turns out to have benefited the operators of the box at first, with the spread then widening, inducing a crisis in the end.

The issues involved, and the necessary remedies, are many, not least making the box a lot more transparent, letting everyone see the working parts: those putting money in, those taking money out, those matching the risk appetite of investors with the risk profiles of borrowers, and those responsible for ensuring that the box works as intended. There seems also to be a need to go back to basics, with all concerned, particularly all the many people operating the box, being reminded what it's for, and the regulators responsible for safeguarding the public interest reminded that the simpler ways of doing things may be more cost-effective in the long term. It will be fascinating to observe how this one plays out and the structural changes that the process will inevitably entail.

Joseph Yam
4 September 2008

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