The global financial crisis highlights the importance of going back to basics.
I published in this column on 10 August 2006 a piece entitled "A Basic Law of Finance", in which I proposed 13 Articles for such a Law. The reason for doing so was described in the opening paragraph:
"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."
The article was written in 2006 when things were brisk. A lot of deals were being done and a lot of money being made, and everybody was having a good time. It seemed to me that finance was indeed "taking on a life of its own, behaving in a manner inconsistent with the public interest". Financial institutions were making a lot of profits and some of their employees earning astronomical amounts. Some people – and I was one of them – argued that if financial intermediaries (institutions and their employees) were making a lot of money, then the intermediation spread, which is the cost of channelling money from those who have a surplus of it to those who are short of it, must be too high. And a high intermediation spread is an indication of low efficiency in the financial system in intermediating funds to support economic activity.
So in "A Basic Law of Finance" I included an 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."
This is easier said than done. In capitalist, free-market and democratic jurisdictions, financial intermediaries often constitute a strong political lobby trying to contain government interference in the financial system, to the extent that the financial system often takes on a life of its own with its basic function of financial intermediation in support of the economy is forgotten, or at best seen as being of secondary importance. There is much attention, for example, on the ups and downs of the stock market and the many derivative products. Indeed, the livelihood of many depends on the ups and downs. But sometimes I wonder whether those involved in the operation of the financial markets realise that, while they have every right to make money buying and selling, the primary purpose of their activities, and ultimately their existence in the financial markets, is to maintain liquidity in the secondary market to sustain interest in the primary market where financial intermediation takes place.
I am glad that the global financial crisis has drawn strong responses from market participants, highlighting the importance of going back to basics. I certainly hope that "A Basic Law of Finance" can provide some insights, at least for us in Hong Kong, in charting the way forward, in particular with regard to how much the Government should be involved. To me the objectives are clear. If the financial system is to fulfil its basic function of providing maximum support to the economy, there is a need for stability, integrity, diversity and efficiency. Since this public interest is not necessarily aligned with financial intermediaries' private interests of earning maximum profits, there is a need for the continued involvement of the authorities to promote and protect the public interest in effective financial intermediation.
To achieve these objectives, the roles of the authorities are clear. I see, in general terms, five of them: regulation of financial markets; supervision of financial institutions; provision of a safety net, particularly for those not in a position to protect themselves; maintenance of a crisis-resolution mechanism, just in case; and development of the financial markets, in particular market infrastructure, which, to me, fits the definition of a public good. How these roles should be arranged or re-arranged within the institutional framework is a challenging task for the Government, having learned a great deal from Hong Kong’s experience, as well as that of others. With much discussion in the many international forums on standard setting still going on, pushing for reforms to address the identified deficiencies, particularly those in the epicentre of the crisis, the challenge for Hong Kong is to identify what suits our circumstances while adhering to international standards. But bearing "A Basic Law of Finance" in mind might help.
Joseph Yam
3 September 2009
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