Paris EUROPLACE International Financial Forum FINANCIAL INNOVATION AND FINANCIAL STABILITY

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