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Paris EUROPLACE International Financial Forum FINANCIAL INNOVATION AND FINANCIAL STABILITY

Explore the benefits and risks of financial innovation, lessons from history, and remedies for financial stability. Discover how structured products influence the current financial turmoil.

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Paris EUROPLACE International Financial Forum FINANCIAL INNOVATION AND FINANCIAL STABILITY

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  1. Paris EUROPLACEInternational Financial ForumFINANCIAL INNOVATIONANDFINANCIAL STABILITY Joseph Yam Chief Executive Hong Kong Monetary Authority 24 September 2007

  2. OUTLINE • Financial innovation – benefits • Financial innovation – risks • History • Lessons • Structured products – the current turmoil • Issues • Remedies

  3. 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 (?)

  4. 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

  5. FINANCIAL INNOVATION – BENEFITS Economy • Higher productive capacity • Higher growth potential • Higher consumption • Greater economic welfare Financial intermediaries • More employment opportunities • Attractive remuneration for innovation

  6. 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

  7. HISTORY High incidence of financial turmoil being preceded by financial innovation

  8. 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

  9. 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)

  10. 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

  11. 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?

  12. 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

  13. 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

  14. 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)

  15. 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

  16. 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

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