Paris EUROPLACEInternational Financial Forum

FINANCIAL INNOVATIONAND

FINANCIAL STABILITY

Joseph Yam

Chief Executive

Hong Kong Monetary Authority

24 September 2007

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OUTLINE

• Financial innovation – benefits

• Financial innovation – risks

• History

• Lessons

• Structured products – the current turmoil

• Issues

• Remedies

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FINANCIAL INNOVATION – BENEFITS

Financial Intermediation

• Higher efficiency in financial intermediation

• Greater diversity of financial intermediation channels

• Better allocation of risks in accordance with different risk appetite

• Greater financial stability (?)

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FINANCIAL INNOVATION – BENEFITS

Fund raisers

• Greater availability of funds

• Lower cost of funds

Investors

• Greater variety of risk return profiles for making investments

• Higher risk adjusted rate of investment return

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FINANCIAL INNOVATION – BENEFITS

Economy

• Higher productive capacity

• Higher growth potential

• Higher consumption

• Greater economic welfare

Financial intermediaries

• More employment opportunities

• Attractive remuneration for innovation

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FINANCIAL INNOVATION – RISKS

• Innovation means new, probably unknown risk areas

• Inadequate understanding of nature of risks

• Imprudent management of risks

• Excessive indulgence and leverage

• Hidden vulnerability of financial system to shocks

• No established remedies to deal with shocks when unknown risks materialise

• Financial instability of systemic dimension

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HISTORY

High incidence of financial turmoil being

preceded by financial innovation

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HISTORY

Financial liberalisation a source of banking crisis

• Liberalisation on access to financial services; greater competition; greater risk taking by hitherto protected domestic banks

• Interest rate liberalisation; taking of greater interest rate risks

• Lifting of lending restrictions; rapid expansion of credit as pent-up demand is met; fierce competition for market shares; channelling credit to asset markets, encouraging asset price bubbles

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HISTORY

Financial liberalisation a source of banking crisis

• Kaminsky and Reinhart: 18 out of 25 banking crises linked to financial liberalisation

• Latin America: Chile (81-83), Columbia (82-85), Mexico (82-84), Peru (83)

• Europe: Finland (91-92), Norway (88-91), Sweden (91-92)

• Asia: Indonesia (92), Philippines (85)

• United States: Savings and Loans (82-91)

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HISTORY

Financial derivatives a source of financial crisis

• Metallgesellschaft – oil futures

• Orange County – interest rate derivatives

• Barings – Nikkei Index futures

• Hong Kong Double Play – Hang Seng Index futures

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LESSONS

• The forces generated by financial innovation are potent

• They need to be properly harnessed if

– benefits are to be realised to the fullest extent on sustainable basis; and

– adverse implications on financial stability are to be avoided

• Question, as always, is how?

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STRUCTURED PRODUCTS– THE CURRENT TURMOIL

• Financial innovation – credit risk transfer through structured products

• Originate-and-distribute model transfers risk assets from bank balance sheets to non-bank sector

• Warehousing, slicing, and funding through conduits and SIVs made location of risks opaque

• Risk transfer eroded credit standards

• Gate keeper of credit quality sub-contracted to credit rating agencies whose models and assumptions may be inappropriate

• Funds made available to less credit-worthy borrowers

• Investors misled on the risks they are taking

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STRUCTURED PRODUCTS– THE CURRENT TURMOIL

• Delinquency rates of US sub-prime mortgages shot up• Mounting losses in sub-prime mortgage backed securities• Growing concern among investors about possible exposure• Spreads in many structured products (particularly MBS, ABS)

widened sharply• Disorderly re-pricing of risks• A loss of confidence in the rating system for ABS• Difficulty in pricing structured products• Liquidity in structured products disappeared• Issuers could not roll over ABCP• Draw on back-up lines of bank credit• Re-intermediation, but low capital adequacy

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STRUCTURED PRODUCTS– THE CURRENT TURMOIL

• Marked rise in perceived bank risks

• Breakdown of confidence in inter-bank market

• Liquidity remains poor notwithstanding injection of liquidity by central banks

• Concern over adverse implications of credit crunch on economy

• Monetary policy response in the US

• Breakdown of depositors’ confidence in the UK – first bank run since 1866

• Response of UK Government – transformation of bank deposits into public debt (Martin Wolfe, Financial Times)

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ISSUES

• Too early to be definitive about causes

• Misalignment of incentives for financial intermediaries

• Credit risk transfer and the risk of re-intermediation

• Reliability of credit ratings

• Opaqueness of where the risks lie in the financial system

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REMEDIES

• Too early to be definitive about remedies

• Central bank injection of liquidity

• Monetary policy response

• Tighter supervision

• Greater transparency

• Avoid knee jerk remedies that may stifle financial innovation