The integrity of the financial system is of great importance to any economy, given the need for financial intermediation to be conducted in a safe and efficient financial system to promote economic growth and development. This is particularly so for an international financial centre, where financial intermediation is conducted in an international dimension, serving the needs of overseas as well as domestic investors and fund raisers. The integrity of the financial system is therefore one of the crucial factors that everyone, including regulators and financial intermediaries, should protect.

As I have often pointed out, the private interests of financial intermediaries in maximising profits are not necessarily aligned with the public interest in promoting the stability, integrity, diversity and efficiency of the financial system. Some might argue that the less efficient the financial system is, the more profitable the financial intermediaries will be. It would be nice to be a shareholder of a bank that has a protected mandate to take deposits at interest of, say, 2% a year and lend the money at 20%. But having to rely on a wide net interest margin is an indication of either high operating costs or inefficient intermediation of funds, or both. Thankfully, with keen competition, authorized and protected mandate notwithstanding, the net interest margin of banks in Hong Kong, at around 1.6%, is among the lowest in the world. Considering the excellent service the banks provide, the healthy profits they make and the very low rate of non-performing loans they maintain, it is actually quite difficult to find another banking system in the world that is as efficient.

Competition drives efficiency. But clearly we must guard against competition eroding profitability to such an extent that it forces financial intermediaries into improper or imprudent behaviour that eventually undermines the stability and integrity of the financial system. Regrettably, this can happen – just imagine the pressure an employee of a financial intermediary is under when, every week or month, he or she has to produce higher and higher contributions to the bottom line, or the pressure faced by the employer when business overheads are running high and market share is declining. But improper behaviour, however innocent it may seem to those engaging in it at the time, is categorically unacceptable, not to mention behaviour of a criminal nature. A financial intermediary abusing the trust of its clients, for example, can be very damaging to the integrity of the financial system.

It is difficult if not impossible for regulators to prevent all crime or improper behaviour. Guidelines can be issued and rules can be made, statutory or otherwise, but the private sector still needs to do business without the regulators examining and approving every deal. Investor education is also important, particularly on how to safeguard their interests. And for those not quite in a position to protect themselves, investor protection schemes may be necessary, notwithstanding the moral hazard involved and the other possible undesirable effects on the behaviour of the financial intermediaries, although one would hope that these schemes would never need to be invoked. The Deposit Protection Scheme to be introduced later this year is a case in point.

Another important factor is the provision of a safe and efficient financial infrastructure to help prevent the abuse of clients' trust by financial intermediaries. The sophisticated information technology available nowadays makes real time gross settlement (RTGS), delivery versus payment (DvP) and payment versus payment (PvP) possible. These are not esoteric or complicated concepts. Basically, they resemble the games of exchanging goodies we used to play as children, when we always wanted to conduct "hand-to-hand" transactions and to have our own hiding places for our treasures. RTGS, DvP and PvP have been built into the financial system to allow parties to financial transactions to obtain delivery or payment straight away. This minimises or eliminates risk and makes the transactions as safe as possible. This in turn reduces the risk of the integrity of the system being undermined, something Hong Kong as an international financial centre simply cannot afford.

Joseph Yam

31 August 2006

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