Introduction
This year's theme, Financial Stability for Economic Growth, is uncannily appropriate in light of the recent and on-going financial turbulence that has cut across the region. The importance of financial stability in Malaysia's, or indeed any nation's, economic growth clearly demands more attention than I can possibly give in the time that I have. And so, I will restrict my input on this critical area to a particular part with which I am familiar, that of a regulator of the Malaysian capital markets.
Role of the Capital Markets in Economic Growth
For those of you who may not be familiar with the capital market development of Malaysia, allow me to give you a brief run-down. Traditionally it has been our banks that have financed our country's economic activity and growth. In recent years and increasingly so, the capital market with its multiplicity of products has come to play a more significant role. These products were typically cheaper than traditional bank finance - hence their attraction. The cheaper cost of funding was made possible by liquid and efficient markets in which these products were traded after the initial capital raising. Liquidity, price efficiency, and operational efficiency - key elements in a market - are, in turn, dependent on the confidence of market participants.
Financial turbulence, or instability, as we have seen, erodes that confidence. And when financial turbulence is prolonged, the risk to systemic stability and financial integrity increases. If this risk is realised, then a systemic crisis will ensue. In other words, a disturbance in one firm, sector or market that impairs the workings of other firms, sectors or markets. It involves a sequence of events that threatens the default of market participants, which in turn threatens a breakdown in the flow of payments that settle financial transactions. Ultimately, this places all financial markets-for equity, bond, money and their derivatives-in jeopardy. Under this definition, the Pan Electric debacle and the recent financial turmoil in Thailand arguably fall under this category whereas Barings and Sumitomo merely increased systemic risk. Financial integrity, on the other hand, talks more to the robustness of financial market institutions and intermediaries, in terms of prudential standards and information disclosure. This typically encompasses areas such as sound clearance and settlement systems of clearing institutions, appropriate capital adequacy requirements, timely disclosure of material information, and satisfactory back-office systems and procedures of market intermediaries.
The Securities Commission, as one of the regulators of the financial markets, has monitored and continues to monitor the financial turbulence to ensure that the risks of disruption to our markets' systemic stability and financial integrity are kept within acceptable limits.
Everyone has a Role to Play: Case Studies
Supervisory regulators by themselves, however, cannot do this job alone. This is particularly the case in Malaysia as we move towards a full disclosure-based regulatory environment. A quick review of some recent financial market crises will show that systemic risks can and do arise from all kinds of places - from one firm, from one sector or market, from abroad.
In 1984, the cornering of the Malaysian palm oil futures market by an individual resulted in massive defaults of contracts and in a subsequent loss of confidence in the Kuala Lumpur Commodities Exchange which led to the eventual closure of the exchange.
A year on, when Malaysia was in the throes of a recession in 1985, the market was artificially pushed up through a series of de facto forward contracts. The demise of one of these companies, Pan-Electric Industries, a Singaporean company listed on both Malaysian and Singaporean exchanges, triggered an unprecedented financial crisis in which brokers refused to honour their obligations. The ensuing debacle culminated in the three-day closure of the Kuala Lumpur Stock Exchange.
More recently, the unauthorised and concealed loss-making trades of one Nicholas Leeson within Barings Futures Singapore over a sustained period of time resulted in the insolvency of Barings Bank.
And finally, in 1996, it was revealed that another star trader, this time at Japanese behemoth Sumitomo Corp, racked up a USD1.8 billion loss over a 10-year spree of unauthorised dealing and price manipulation. His team controlled over 5% of the world's copper supplies and accounted for over half the copper trades on the London Metal Exchange. In March 1996, he faced a phalanx of heavyweight speculators led by George Soros who tried to drive copper prices down, spurring investigations into suspected price manipulation and subsequent exposure of the biggest unauthorised trading loss in history. In the weeks following the news of the trader's activities, copper prices fell by 10% and are still declining. It is widely anticipated that a rebound is unlikely for another two to three years.
While we accept and believe that the responsibility for the management of systemic risk lies primarily with those who oversee the operation of the entire market and who have responsibility over the smooth-running of the clearance and settlement system - in short, regulators, exchanges and clearing houses, all market participants also play an important role for the simple reason that they are the players as the examples I have cited demonstrate.
The Role of Regulators
But before I talk about what we expect of market participants, it is only fair to tell you what regulators do and can do in the management of systemic risk. Let me be clear from the outset, it is impossible to guarantee against a systemic crash - to pretend otherwise would be like Canute standing at the beach ordering the tide away. This said, regulators can and do take expedient measures to minimise such risks faced by exchanges and other financial institutions. These measures typically include the development of early-warning signals i.e. the monitoring of potential 'weak-spots'; efficient trading systems; co-ordinated market surveillance; risk management; contingency planning; and, perhaps most important of all, education. I believe that a well-informed, educated investor community with an efficient and fundamentally sound market will go a long way towards protecting the economy from long-term damage in the event of a systemic crisis. At present, unfortunately, such an utopia remains a goal yet to be attained, even for the most developed of markets.
To protect the system and, by extension, the market and its participants, regulators must also be prepared to intervene in the market before a disruption can occur. If necessary and in extremis, they must be prepared to allow market participants to fail for the greater good of the market to minimise the risk of system-wide disruption. This, however, as you will appreciate, requires not only careful handling of market expectations but also a need to minimise the risk of moral hazard that exists as a result of the regulators' presence in the market.
For this reason, the SC has impressed upon the KLSE to implement a risk-based capital adequacy framework which are more relevant to the maintenance of market integrity at the level of the exchange and clearing house, security depositories and clearing members. Much as we might like it to be, risk-based capital is not some kind of super-shield under which our system can be protected. As critical as it is, prudential financial requirements are but one aspect of prudential and financial regulations which in toto help to ensure systemic stability and financial integrity. It is therefore appropriate that YAB the Minister of Finance and the Deputy Prime Minister announced, in his recent budget speech, plans for a new framework for client asset protection. These client asset rules ensure that, in the event of a failure, client assets are protected and that clients do not suffer losses as a result of the failure. Along side this initiative, the SC is currently working on rules and best-practices for the conduct of business to maintain the integrity of market intermediaries so that they and their clients are protected from a disruption in general operations.
Role of the Market
If you do not already see that everyone has important designated roles to play from my brief run-down on recent crises, I believe that this last bit - the part on conduct of business - clearly shows that market intermediaries must assume their responsibilities alongside those of the regulators and market institutions. Without their help, we as regulators are faced with a task that is practically impossible.
Let me reinforce this point without in any way abrogating regulatory responsibility for ensuring systemic stability and financial integrity. In the case of Sumitomo, the lack of managerial control over the excessive risk-taking and the lack of disciplinary action against numerous complaints from as early as 1990 are key factors which led to the sizeable, but arguably avoidable, losses that the firm suffered. With Barings, the morality tale is much the same: a breakdown of managerial controls because of complex reporting lines and confused matrices of responsibility; a management information system that was not properly aligned to the risk characteristics of the business - for otherwise, how could the bank's entire capital base be sent over to Singapore to support the activities of one trader, and apparently without senior management knowledge?
To argue that these two firms did not trigger the collapse of their respective markets is to miss the point. In Barings' case, immediate and decisive efforts to control the damage (which included co-ordination among bankers, regulators, exchanges and market participants in the UK, US, Singapore and Japan) and a little luck - in the form of ING which took over Barings' operations after it declared bankruptcy - were key to the containment of the potential systemic consequences.
Conclusion
I hope that, in this short space of time, I have shown the role that all market participants have to play. At the risk of sounding repetitive, let me say again. Regulators and supervisors bear the ultimate responsibility for the maintenance of financial stability in the capital market. But the front line of this responsibility falls squarely at the feet of market intermediaries - at the likes of the stockbrokers and the bankers.
What matters most of all at a time of stress is not to buckle under. It is important to ensure that the system holds up - that laws, rules, regulations and best practices are adhered to. Only then can order and confidence be maintained. Otherwise things will fall apart.
And as you would well appreciate, in a modern economy, financial markets are key drivers of sustainable long-term growth. Therefore the whole edifice that supports those markets, including financial stability, is more than a requisite for economic growth, it is a sine qua non.
