The need to focus on systemic risk is increasingly recognised.
The financial authorities in many jurisdictions are now working to design a model for a macro-prudential approach to financial regulation and supervision. In the United States, for example, Federal Reserve Chairman Ben Bernanke suggested, in a speech delivered on 10 March 2009, a systemic risk authority with the following functions:
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monitoring large or rapidly increasing exposures – such as to sub-prime mortgages – across firms and markets, rather than only at the level of individual firms or sectors;
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accessing the potential for deficiencies in evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products to increase systemic risks;
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analysing possible spillovers between financial firms or between firms and markets, such as mutual exposures of highly interconnected firms; and
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identifying possible regulatory gaps, including gaps in the protection of consumers and investors, that pose risks for the system as a whole.
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These are useful pointers for our own work in this area. But obviously the description of these functions reflects deficiencies in the United States and is geared to addressing them. In Hong Kong, we have already gone quite a long way in this direction, for example in monitoring large or increasing exposures. Readers are, I am sure, aware of the attention we have been giving to the exposure of the banking system to the housing market and hence its vulnerability to volatility in property prices, or to the fast-developing Mainland market, and our corresponding guidance to the banks on managing the associated risks. And there are other specific aspects or characteristics of our financial system that merit special attention, for example its size relative to international financial flows and the degree of market concentration. We obviously need to develop our own mechanism for a macro-prudential approach to financial regulation and supervision, taking account of our existing framework, including the institutional arrangements, and guidance provided by international bodies such as the Financial Stability Forum and the Basel Committee on Banking Supervision.
All concerned need to engage in a serious discussion of this matter. The fact that we in the HKMA have, on our own initiative, incorporated such an emphasis in our work for some years is not enough. The fact that Hong Kong has, so far, avoided a breakdown of our financial system akin to that seen in other jurisdictions during the crisis – whether because of foresight, hard work in the past or, frankly, luck – should not make us complacent. There is a need to intensify effort and for more comprehensive consideration going beyond the traditional view of the responsibilities of a central bank.
A natural starting point would be an intellectual framework within which to identify specific focuses to guide the macro-prudential approach to financial regulation and supervision. I have been going through the relevant reports of various international financial forums. Two distinguishing features have recently been identified that may be of use to us. First, there is a focus on the financial system as a whole, with the objective of limiting the macroeconomic costs of episodes of financial distress. I am sure seasoned investors look at the totality of their investment portfolios as well as the individual components. While every component requires close attention, large losses for individual components are sometimes unavoidable. But as long as the investment performance of the portfolio as a whole is not excessively and adversely affected, the individual losses, undesirable as they may be, should not cause too much agony. It would, however, be a serious problem if there were a large loss for the portfolio as a whole, which could well be brought about by highly correlated performance of the individual components or too high a concentration in risks of a particular nature. In the macro-prudential approach to financial regulation and supervision, one can think of the financial system as the portfolio of investments.
Secondly, there is the need to recognise that the aggregate risk for the system as a whole is dependent upon the collective behaviour of the individual components of the system – the individual financial institutions, the various financial markets and the market participants. There is a possibility that actions of the individual components of the financial system, which could well be optimal from their narrow perspectives, may collectively be damaging for the system as a whole. The current financial crisis has clearly exposed this issue and that is why there are calls for greater emphasis on a system-wide approach to financial regulation, on top of the traditional micro-prudential focus on the safety and soundness of individual institutions.
Joseph Yam
19 March 2009
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