Speech By DPM Lee Hsien Loong, at the SESDAQ 10th Anniversary, on 4 Nov 1997, Westin Stamford Ballroom

Date: 4 Nov 1997

INTRODUCTION

1   I am happy to celebrate with you SESDAQ's 10^th anniver-sary. SESDAQ has established itself as a second board on the Stock Exchange of Singapore. It has provided small and medium enterprises with a useful source of funds, which are a critical supporting factor for entrepre-neurship. 80 companies have listed on SESDAQ over the past decade, of which 20 have since made it to the Main Board. Its total market capitalisa-tion is now almost $5 bn.

2   However, despite SESDAQ's achievements, it has still not clearly established itself in investors' minds as a high risk, high return play. The SES should now study ways to expand SESDAQ's role, for example how to develop SESDAQ into a source of seed capital for startup firms, well before they have built up a track record.

3  . Such a review would fit into the Government's current comprehensive study of its strategies and approaches towards regulating and promoting the financial sector. Our aim is to develop the sector further, and make Singapore one of the key financial centres in our time zone, and in the world. We need to modify the style and balance of regulation and supervision, strengthen our domestic financial institutions, encourage the private sector to play a bigger role in developing the financial industry, and place greater reliance on market forces. Incremental improvements to established policies will not suffice. We need to rethink fundamentals and chart new directions.

THE DEVELOPMENT OF SINGAPORE'S FINANCIAL SECTOR

4   The financial sector has played a major part in Singapore's success story. Financial services have consistently grown faster than the rest of the economy, and now account for 12% of GDP. The Asian dollar market has made us a dominant offshore banking centre in Asia. Our foreign exchange market is the fourth largest in the world. Fund management activities have also grown rapidly in recent years, as has the trading of foreign securities. SIMEX has made a niche for itself as the leading futures exchange in the region.

5   Growth has been not only dramatic, but also orderly and well-controlled. Our local banks have some of the best debt ratings in South East Asia. No bank has failed. We have avoided most of the problems experienced by other financial centres in the region. We learnt from the Pan-El crisis in 1985, and tightened up management and regulatory controls. In 1987, we took Black Monday in our stride. Later we avoided the BCCI debacle, and prevented Barings' spectacular collapse from inflicting any losses to SIMEX or other Singapore financial institutions.

6   The regional financial turmoil is the most recent testimony to the soundness of our financial system. The signs are that despite this external instability our economy grew strongly in the third-quarter, although our growth is bound to be affected somewhat over the next year or two. Because of our prudent macro-economic and financial policies, confidence in the Singapore dollar and our financial institutions remains unshaken.

DRAMATIC WORLDWIDE CHANGE

7   However, we cannot simply extrapolate this success, or the policies which have produced it, into the future. The financial industry worldwide is undergoing rapid change and ferment. The rules of the game are changing, and so are the players. The current World Trade Organisation negotiations to open up the financial sectors in member countries to foreign participation will hasten a process which is in any case already well underway.

8   The first driving force behind this revolution is technology, especially information technology and telecommunications. These allow financial institutions to introduce new products and techniques to arbitrage markets and manage risk, and new distribution channels like online banking. They enable, indeed strongly encourage, institutions to go for huge economies of scale, and to operate globally to survive and thrive.

9   Technology is breaching geographic, industry and regulatory barriers. Markets are becoming globalised. Trading takes place around the world and round the clock. Capital moves in and out of markets and financial instruments nearly anywhere in the world. The current regional disturbances illustrate this vividly. Thailand's problems set off a chain of events that contributed to pressure on Hong Kong stocks and the Hong Kong dollar. This in turn rattled stock markets in the US and Europe. And when Wall Street crashed on Monday 27 October, the convulsion and the aftershocks shook stock markets on every continent.

10   The second driving force for change is fierce borderless competition. This is fostered by both technology and the lifting of regulatory barriers, and is leading to more efficient financial systems worldwide. Gone are the days when institutions were protected by government regulation and barriers to entry, and could monopolise a geographic market and earn comfortable profits collecting economic rent.

11   Banks are facing increased competition in financial markets, because of new sources of funds for companies, and new channels for individual savings. The traditional functions of banks - to collect money, lend it out, and earn a profit on the interest spread - are being split up among different institutions, each carrying out specialised functions more efficiently and with narrower margins.

12   In America and Europe there has been a surge in mutual funds, as more people have channelled their retirement savings into these funds to earn better long-term returns than bank deposits. Companies are raising funds in increasingly sophisticated ways on the capital markets, instead of borrowing from banks. And bank loans such as mortgages are being securitised, to take them off balance sheets.

13   Institutions are finding that their competitors are not across the street, but across the globe. In the US, online brokers like Charles Schwab are already doing stock trading on the Internet, at one quarter the usual cost. Software companies like Microsoft now offer transactions online.

14   Financial institutions are being driven in an unceasing quest for higher efficiency and lower costs. Margins are being shaved, especially in traditional activities like plain vanilla loan syndication and under-writing, and the trading of securities.

15   The result is a wave of mergers, acquisitions and corporate restructurings, now sweeping financial institutions in the US, Europe, and Japan. Commercial banks are marrying up with investment banks. Insurance companies have been acquiring securities firms. The consolidation will lead to the emergence of new mega-players, with the economies of scale, market power, IT capability and expertise to dominate whole regions, or specialist services worldwide.

16   The new technology-driven strategies, increased competition and globalisation have also encouraged a consolidation of financial activities within fewer major centres. In Europe, London is the pre-eminent centre, eclipsing Zurich, Frankfurt and Paris. In and around the City of London, 600,000 people work in the financial industry, or businesses related to it. It is not a British industry, but a global, cosmopolitan one.

17   A similar consolidation will happen in our time zone. We cannot tell how many major centres the Asia Pacific will eventually have. But whatever the final count, we want to be in that number.

18   This bracing environment opens many exciting opportunities in financial services that embody innovation and expertise, such as fund management products and complex derivatives. But it also brings new risks to individuals, institutions, and the financial system as a whole.

19   There have been numerous accidents, some involving new instruments, some caused by obvious lapses of internal controls. They have occurred even at some of the most well-managed and respected banks. The potential consequences of failure are now far graver. When something goes wrong in an institution, losses can mount exponentially, almost by the hour. In the case of Barings, a 233 year-old merchant bank, Nick Leeson ran up most of his losses in the final few weeks before the collapse.

20   Barings was a small institution by international standards, so the damage was relatively easy to contain. But the collapse of a mega-institution poses a real risk of systemic failure. And with more tightly coupled global markets, the problem will very likely cascade across the international system.

RETHINKING AND DEBATE

21   This dramatic worldwide revolution in the financial industry is causing governments and regulators everywhere to review their approaches to regulating and supervising the industry. In the US, the separation between commercial banks and investment banks has become more porous. The Glass-Steagall Act will continue to be loosened by market forces, even if Congress does not repeal it.

22   In Britain the new Labour Government has shifted responsibility for banking supervision away from the Bank of England, but left the Bank still responsible for the stability of the financial system as a whole. Britain is setting up a new omnibus regulatory agency, the Financial Services Authority, combining 9 different existing regulators, to oversee all components of the financial industry. The industry is watching with fascination and apprehension how this will all work out.

23   In the developed countries, there has been substantial questioning and debate on how governments should manage financial institutions and markets. There is broad consensus on the goals of public policy: at the macro level, to protect the stability of the financial system; and at the micro level, to protect individual investors and depositors. Now the debate is on how to achieve these two goals in a way which ensures the maximum effectiveness and efficiency of the financial system.

24   The debate is difficult, because there are tensions and trade-offs between the macro and micro goals. For example, if policies go too far in protecting all depositors and investors, it creates a problem of moral hazard, that virtually ensures that institutions and markets will not function efficiently and effectively.

IMPLICATIONS FOR SINGAPORE

25   As a major financial centre, Singapore cannot isolate itself from these global trends, or ignore the issues which they raise. Tried and tested formulas will not necessarily be best in the next phase. We need to develop new principles and strategies to enable our financial sector to prosper into the 21^st century.

26   Our review must cover not only the offshore financial institutions, but also domestic banking. Both must keep track of what is happening around the world and stay up to date. It is not tenable to keep the world outside our door. Firstly, technology will make this less and less feasible. Secondly, Singapore consumers and corporations need financial services that are up to world standards, otherwise the rest of our economy and our overall competitiveness will be affected. Thirdly, a major growth area for our domestic institutions is offshore, in the region. Unless our institutions can hold their own against the competition domestically, they have little hope of competing without home ground advantages in the far more difficult regional environment.

OUR TRADITIONAL PRINCIPLES

27   Up till now, our approach to regulating and supervising the financial sector has been to set high standards, establish strict rules, and take minimum risks. When we started, we were an improbable place to develop a financial centre. We had no track record or credibility. We had to earn it the hard way, by establishing a reputation for honesty and competence.

28   In this we were unlike Hong Kong. Hong Kong had a British umbrella, and hence could afford to be more tolerant of failures of institutions and ambiguous market practices. It is said that in Hong Kong anything not expressly forbidden is permitted, whereas in Singapore anything not expressly permitted is forbidden. This is an exaggeration, but it captures an important difference in the two systems. Had Singapore been lax and then run into difficulties or scandals, bankers would have lost confidence in us, and we would have failed to grow into a major financial centre. This has happened to many other aspiring financial centres.

29   Therefore we set out to attain and maintain the highest possible standards of professional integrity and sound financial management. We established strict rules and enforced them vigorously. We sought to protect not just the financial system as a whole, but even individual institutions from failing. We did our best to protect the public from fraud and sharp practice. We even crafted regulations to shield the public from risky ventures and business losses.

30   Because of this general approach, we have regarded innovative products and ideas warily, in the interest of preserving stability, minimising risk and protecting investors. We have tried to manage new developments in a gradual and orderly way. Sometimes we have imposed our judgment of what risks individuals and institutions should be allowed to undertake. For example, we have not encouraged trading of covered warrants, or investments in unit trusts covering unfamiliar parts of the globe.

31   We have been especially careful to protect Singaporean depositors and investors. We have kept the domestic and offshore banking sectors separate, and regulated the domestic sector more stringently. Local entities have been partially insulated from the bracing international environment, although our domestic market is more open to foreign institutions than most other countries in the region.

32   So far, this approach has promoted rather than hindered our growth. However, the tradeoff has been that we have sometimes been slower than others to introduce new products and develop new markets. More important, we have not fully exploited the expertise and enterprise available in the private sector. Too often the industry has waited for government to signal its acceptance of change or even to take the initiative, rather than leading developments and actively contributing their ideas.

NEW DIRECTIONS

33   What I have described has been the Government's long standing policy, which MAS has faithfully and successfully implemented. But the global trends in banking and finance make a review imperative. Besides our financial sector is more developed, and our competence and credibility no longer in question. And Singaporeans are better educated and more financially savvy, wanting to manage their own wealth and make their own decisions, financial or otherwise.

34   We must shift our emphasis. We need to regulate the financial sector with a lighter touch, accept more calculated risks, and give the industry more room to innovate and stretch the envelope. This process should start now, notwithstanding the current regional uncertainties. It is a strategic shift, not dependent on short term ups and downs of economic fortunes. Indeed by starting now, our financial sector will be more ready to play a significant role as the region recovers.

35   We need to promote a more competitive, dynamic and innovative environment. In a dynamic global industry, Singapore can only stay near the leading edge if it too has that climate of ferment and innovation. This is not just having bright ideas, but being willing to break new ground and create fresh opportunities.

36   The private sector must play a larger role in developing the industry. We welcome constructive feedback, proposals and initiatives from practitioners. The Government will support and nurture, but it cannot direct the industry. In a fast-changing and dynamic business, the government cannot know, let alone control, everything that is going on.

37   Human resources will be crucial. Singapore has very good hardware - telecommunications, Changi airport, computer systems for trading and settlement. We must continue to improve on these important advantages over our competitors. But our most urgent constraint is people rather than hard-ware. The key success factor is intellectual capital. Singapore must be the marketplace of choice which gathers the best financial talent, both domestic and foreign. We need to nurture promising participants, encourage talent to work in Singapore, and get them to play in a conducive and freely competitive environment.

NEW PRINCIPLES

38   What new principles should guide the Government's policy towards the financial sector? What will the "lighter touch" consist of? The old approach was to maintain high standards, establish strict rules, and take minimum risks. We must keep the first of these principles, and modify the other two.

39   We must maintain high standards of integrity and sound financial management, which have become associated with Singapore. These standards must never be compromised. There is no contradiction between keeping standards high and creating a more dynamic and vibrant environment. The regional economic problems underline the critical importance of maintaining both international and domestic confidence in the soundness of our financial system. If banks, and also their regulators in their home countries, lose faith in Singapore, they will take their business away.

40   We are now in a stronger position to take risks. But we are still unable to recover from a banking scandal as effortlessly as say London. MAS must continue to do the things it has done well, overseeing the financial sector professionally, vigilantly and proactively.

41   We need to shift emphasis from regulation to supervision. In banking jargon, regulation means establishing capital requirements and setting rules on prudential standards and practices, what can and cannot be done. Supervision, on the other hand, means monitoring and inspecting individual institutions for compliance with these requirements and rules, and ensuring that internal management controls are in good shape.

42   If we rely heavily on regulation to maintain high standards, we will need more rigid rules. And since these rules will apply to all institutions, they will hinder growth and innovation in the good institutions.

43   By depending less on regulation and more on supervision, we can deal with good and bad institutions differently. We should not impose onerous requirements which penalise many good institutions, just to safeguard against a few bad ones. Our supervisory style should incorporate a greater understanding of business needs, and be more tolerant of business imperatives. This will also help reduce regulatory costs.

44   This change is crucial, but it will take considerable effort and time to realise fully, because it requires changing operating procedures, and, more difficult, expectations of both participants and the authorities.

45   Our attitude towards risk must change. The MAS has to take less conservative approach to risk. It should allow financial institutions to assume the risk profiles which they themselves are comfortable with, within prudential limits. Sound standards are necessary, to provide the basis for prudent risk taking. But we must recognise a trade off between safety and business opportunity. For example, it is riskier to lend and invest in regional markets than in the domestic market, but we cannot therefore avoid going regional.

46   We should focus more attention on systemic risk, rather than protecting individual participants, products, or projects. The supervisor's primary responsibility is to avoid major disruptions to financial markets and a loss of confidence in the financial system as a whole. While the supervisor needs to protect depositors' interests, he also has to enable financial institutions to take considered business risks. We need a judicious balance between avoiding risks and grasping opportunities. Ultimately what risks to accept in our financial system is a matter of judgement, not a technical issue with a right and wrong answer.

47   Sometimes taking risks will result in unanticipated losses - that is what risk means. Deciding what risks a bank should take is the job of the bank's management and board of directors, who are responsible to the shareholders. The supervisor will not stop a bank from taking what he might himself consider a doubtful risk, so long as bank management controls are working, the bank is meeting appropriate prudential requirements, and it discloses adequate information to shareholders and the market.

48   We should allow investors to judge and take business risks for themselves. We must distinguish clearly between business risk on the one hand, and fraud and sharp practice on the other. We will protect investors from the latter, for example, by acting firmly against insider trading. But that should not extend to second guessing business decisions, whether by individuals or firms.

49   This requires a change of mindset. The public must learn to make investment decisions for themselves, and take responsibility for the outcomes, good or bad. Just because a stock is listed on the SES, and CPF savings can be used to buy SES stocks, does not mean that all SES stocks are good investments, much less that the SES or the Government has endorsed the stocks. In exercising judgment and taking risks, there are bound to be mistakes and failures. Success means learning from mistakes and failures, without ceasing to try.

50   The man in the street will never become a sophisticated investor or financial analyst. He will not understand the ins and outs of calls and puts, warrants and futures. But he should at least know that there are risks that he does not fully comprehend, and refrain from venturing onto risky ground. We should signpost risky ground with danger signs, not cordon it off with triple barbed wire fences.

51   It is neither possible nor desirable to decide on behalf of Singaporeans what they can or cannot invest in. Some Singaporeans use their savings to buy properties abroad, often in countries where the laws are unclear. Others, more adventurous, even invest in ostrich eggs! Yet we do not propose to bring ostrich egg trading under the MAS Act. The rule must be caveat emptor - let the buyer beware, and watch out for his own interests.

52   What we can do is to develop a sub-industry which provides the public with reliable and unbiased information and advice, from independent advisors who have no vested interest in selling their own products. We should also encourage sector groups to develop and enforce industry standards. Such standards of good practice will help protect consumers against unethical conduct.

53   We should rely more on market discipline and full information disclosure to protect investors, rather than extensive regulation, formal or informal. The regulator's role is to make sure there is transparency and full disclosure, so that the playing field is level. Then the public can decide which institutions are soundest, and which companies are worth investing in.

54   For example, when a listed company seeks shareholders' approval for some proposition, the regulator's duty is only to ensure that the issue has been honestly and fairly put to shareholders, and that the facts and numbers are correct. It is up to the share-holders to decide to accept or reject the proposition, and for the markets to judge whether the share-holders have decided wisely.

55   Similarly, we must raise the standards of information disclosure for banks, to bring them fully in line with the major industrial nations. Currently they even lag behind some countries in the region. Shareholders and customers need adequate information about banks, to assess for themselves what risks the bank is exposed to, and how safe their investments and deposits are.

56   If investors and depositors are to have more freedom of choice, and market discipline and disclosure standards are to play a large role, then financial institutions must have very robust internal risk management, control and audit systems. This will allow us to minimise micro-management of financial institutions and activities and allow more free play, for example freer entry and exit from businesses, and movement of professionals within the industry.

57   To quote Alan Greenspan, "we must be assured that with rare and circumscribed exceptions we do not substitute supervisory judgments for management decisions. That is the road to moral hazard and inefficient bank management" ¹.

58   Our regulations should provide greater transparency. Rules should be as clear as possible. Things which are not expressly forbidden, but are informally and administratively discouraged, should be kept few. The authorities should also avoid having to approve individual transactions case by case. There will be times when the central bank cannot explain why it took certain decisions, even though it has good reasons. And moral suasion, or as Americans call it "jaw-boning", must remain an instrument in MAS' armoury. Every central bank needs this. But we can make the rules clearer - what can and cannot be done, the penalties for infringement and the avenues for appeal.

59   Rules will always have some unclear areas, particularly when new products are introduced which were not foreseen at the time the rules were drafted. Not every grey transaction is suspect. Sometimes the rules will be out of date, or will have been deliberately framed broadly so as not to be quickly overtaken by developments. Institutions need some leeway to operate in such areas, pending new rules. They must have the confidence that should they do something in good faith which is later ruled out of order, they will not be penalised.

60   It is the duty of the regulator to be sceptical of human motives. But it is also our policy to distinguish between a traffic and a capital offence, and not to treat everyone as a sharp operator until proven otherwise.

61   We must build a closer partnership between government and the industry. The Government will promote a more open and friendly operating environment. It will actively consult the industry for views. The relationship between the regulator and the regulated should be arms length but not adversarial. Market practitioners are in the best position to help regulators keep abreast of new developments in the industry. Candid, thoughtful feedback, including dissenting views, is essential to help the regulatory authorities fine tune policies and avoid mistakes.

62   What SES did with the latest proposed amendment to Chapter 9B of the Listing Manual, circulating it widely to the financial community for comments, should be standard practice whenever we make a major change to the rules. In this spirit, I have invited SES to work with us on a comprehensive review of the regulations and structure of the securities industry.

63   The whole approach towards risk which I have described - to emphasise systemic risk, to allow participants to judge their own risks, to depend on transparent regulations, disclosure and market discipline, and to build a partnership with the private sector - rests on one more fundamental point. The primary responsibility for ensuring that financial institutions function in safe, sound and efficient manner rests with the institutions themselves, and their managers and directors. The supervisor will guide and aid these institutions towards these goals. This is already the prevailing wisdom in the developed economies. As always, greater freedom brings with it heavier responsibility.

PROMOTION AND DEVELOPMENT

64   Besides supervising the financial sector, MAS is also responsible for policy thinking, development of the sector, and client servicing of institutions. The Government must have a clear idea of how the sector is developing, gather industry views on promising growth areas, and help bring desirable activities to Singapore. Although it will not micro-manage, it will often have to play an active role, for example in promoting the use of IT for finance, and designing policies and tax incentives to develop promising sectors.

65   In a competitive environment, the businesses with the most potential will not always come to Singapore by themselves. We have to market ourselves and bring them here. The financial sector is unlike manufacturing, because most of the major players in the world are already here. We are therefore promoting new activities rather than new entities. But offering innovative products and services also requires modifying rules and redefining boundaries. This can only happen expeditiously if the innovators, the regulators and other parties involved work together to bring it about.

66   Financial institutions also need help to deal with the many government departments and agencies, for instance to bring in key people who are experts in these new areas, or to settle tax issues with IRAS. This is how the Economic Development Board looks after its clients who have invested in manufacturing operations in Singapore, providing them with one-stop service.

67   MAS has all along been providing one-stop service to financial institutions. But the scale and scope of the industry has expanded, and MAS needs to reinforce and strengthen the team responsible for policy and development. We must do more to institutionalise these non-supervisory functions in MAS.

68   Many bankers have suggested to me that regulation and development are incompatible functions. They worry that MAS will be too cautious in development, because its primary mission is regulation. They propose that some other agency instead of MAS be put in charge of development.

69   I am not convinced. There is a tension between these two functions, and the officers inspecting institutions should not also be charged with client servicing. But intimate cooperation between the regulator and developer is vital. This is easier achieved within one organisation rather than by splitting the functions between different agencies. MAS should continue to be responsible for developing the financial sector, of course working closely with other agencies like MOF and IRAS, and even outside the MOF family, with EDB and NCB. But how to build up this capability within MAS is something we will have to consider.

THE FINANCIAL SECTOR REVIEW GROUP

70   The Financial Sector Review Group has not yet completed its work. Nonetheless let me sketch briefly how it is proceeding.

71   Firstly, MAS has briefed us thoroughly on the present policy thinking and rationale on regulating, supervising and developing the financial sector. This has been an especially valuable education to me personally, as I have had little direct experience of this sector.

72   Secondly, we are tapping MTI's Committee on Singapore's competitiveness, particularly the working groups under Mr Peter Seah's financial sector sub-committee. We have met several groups to discuss their recommendations. I have encouraged them not confine themselves to incremental improvements, but to make bold proposals where justified. I have told them that if all their proposals are accepted, it probably means that they have not been radical enough.

73   Thirdly, I have been meeting individuals from the financial sector, both Singaporeans and non-Singaporeans, to get a direct feel for the people in industry and their views. Many of those I have met have taken the trouble to set down their views in writing, putting forward ideas and suggestions. Their many lucid insights and valuable proposals have complemented what I have learnt from the regulators. I wish to thank publicly all those who have contributed so far, and encourage more to come forward with their views.

74   Fourthly, we have engaged external advisers, and are in the process of commissioning a strategy consultancy firm to do a study. The study will assess Singapore's strengths and weaknesses, identify promising areas for development, recommend policies and strategies, and review our approach to regulating, supervising and developing the financial sector.

75   The Review Group will not publish a comprehensive final report. As we reach conclusions on individual areas, we will announce and implement them, beginning early next year. There will be many issues, because there is no single magic potion for developing and supervising the financial sector. But all the issues will fit into the major themes of the review - developing Singapore as a financial centre; developing our domestic financial system; modifying the style and balance of regulation and supervision; involving the private sector more; and relying more heavily on market forces. The principles outlined earlier will give coherence and consistency to the programme.

CONCLUSION

76   Changing policies is never easy. It is harder to change policies which have been extremely successful and which continue to yield results, than policies which have failed and must clearly be abandoned. Yet we have to look ahead and prepare for major changes in our operating environment.

77   We must develop the new approach fully, apply broad principles to specific rules and policies, and most importantly shift the mindsets of the regulators, the industry and the public. This speech is the start, not the fruition, of our efforts. The changes will take several years to work through. There are many difficult decisions and much hard work ahead. But if we persevere, we will eventually arrive at a new paradigm.

78   In many countries, dramatic financial deregulation packages have led to severe problems several years later. If we move late, we will be forced to make major changes in a hurry. Both regulators and participants will have less time to adjust to the new environment. More mistakes and accidents may happen.

79   By moving early, we can choose the timing and pace of the changes. Then through a series of controlled adjustments, we can navigate a major policy shift, build on the success of our last quarter century, and make Singapore one of the major financial centres in the world.

¹Remarks at the International Conference of Banking Supervisors in Stockholm, 13 June 96.