Reforming financial sector and promoting capital market development - with special reference to Malaysia

Abstract

A financial revolution has been sweeping the developed world from the seventies. The financial revolution we are referring to and which has taken place in the West has been characterised by the emergence of fund managers and non-bank financial institutions (FIS) which have quickly displaced the banking industry as the biggest mobiliser of savings on the one hand and as the biggest investor and lender on the other hand. In the face of this onslaught, the banks have had no choice but to transform themselves from being intermediaries of credit to being intermediaries of risk. This transformation of the banking industry has been facilitated by the rapid development of capital markets, of new risk management products (many of which are in the nature of derivatives), and of securitisation. Thus the banks are now engaged more in the origination and servicing of loans and less in their financing as well as more in the arranging and underwriting of debt issues but less on straight lendings. To be in a better position to discharge their new role in pricing, warehousing and placement, the banks have had to develop expertise in trading and market making in such markets as the currency, money and bond markets. The restriction on and the under-development of capital markets and non-bank FIs has meant that Asia unlike the West, is over-dependent on its banking industry. And Asian banking is more traditional and inward-looking. Given the influence of banks on money supply and the high risk nature of banking, this over-dependence has increased the macroeconomic vulnerabilities and hence the risk profile, of the Asian economies. And unlike fund managers and the non-bank FIs, as the banks are engaged in the payment functions, over-reliance on banks have also increased the exposure of the Asian economies to sysemic risk. The reduced fear of disintermeditation has also not given the banking industry the right incentive to move with the times from being an intermediary of credit to being an intermediary of risk. This factor combined with inappropriate regulation has dampened the development of capital markets, risk management products and of risk intermediaries as well as of trading and market making. This deficiency can become catastrophic, as in many Asian economies, when the high-risk banking industry operates under a regime of pegged exchange rate and open capital flows or inconsistent macro-policies. The high-risk nature of banking can arise from the high gearing and asset-liability mismatches that characterise this industry. Poor credit decisions can aggravate the problem. Regulators and even bankers often forget that to earn a ringgit from lending, a bank has to put at risk a 100 ringgit. The high gearing may in fact create the incentives for risky or imprudent lending. And the massive asset- liability mismatches can convert a liquidity crisis into a solvency crisis. A run on banks can cause a multiple contraction in credit and hence lead to macroeconomic instabilities. This is unlike the situation in the fund management industry where the risks are borne by the investors and where any differences in the liquidity needs of individual investors and the maturity profile of the investment portfolio can be met by a liquidation of the underlying assets. Such liquidations will lead to price volatility, which risk has to be borne by the investor. But as any funds outflow has to be exactly matched by an inflow, liquidity and systemic risks are minimised.