Dr Ackermann, Excellencies, Ladies and Gentlemen,

Introduction

It is my great pleasure this afternoon to join my fellow central bankers and regulators in a discussion of this very current topic. As MAS performs both the functions of a central bank as well as a financial regulator, I will be taking on both perspectives this afternoon.

2   As you all know very well, the recent market turbulence was triggered by concerns over a very specific segment of high-risk borrowers, but very rapidly spilled over more broadly to other credit and asset markets that were fundamentally sound. With the continued growth of global capital mobility, such spillover effects are likely to become ever more pronounced, and in this regard, financial authorities have to work together in order to be proactive and effective in fostering financial stability, while allowing the positive effects of globalization to continue.

Role of Central Banks and Financial Regulators

3   In today’s marketplace, the roles of “ringmaster” and “facilitator” are not mutually exclusive. Global capital has become a way of life and there are good reasons why many would want to tap into these flows in order to achieve greater economic potential. The “ringmaster” role becomes relevant as we acknowledge that certain checks and balances need to be put in place in order to facilitate these flows in an orderly and sustainable fashion.

4   The ringmaster structures the circus program so as to facilitate the performances of the various acts. He also ensures that the safety nets and protective barriers are put up to protect both performers as well as the audience when the more risky acts come into the ring. In much the same way, one key responsibility of financial authorities is the maintenance of reliable infrastructure to facilitate the smooth functioning of global capital.

5   For example, the ease of global capital mobility was not the only culprit during the Asian Financial Crisis, as equally guilty was the absence of robust financial market systems and infrastructure to handle the influx of capital when markets were opened up to international investors. Apart from the building of such structural capabilities, financial authorities should be unobtrusive during day to day operations, only to step in when disorderly behaviour or market failure makes it necessary to do so in order to preserve financial and macroeconomic stability.

The Central Banker’s Toolbox

6   In recent debates, much has already been said about the issue of potential moral hazard when financial authorities intervene in markets. According to that argument, the assistance of financial authorities for struggling institutions could have the undesirable effects of encouraging risky behaviour in the future and undermining the efficient pricing of risk. On the other hand, many bankers would argue, as some of you in the audience have, that the incentives for prudent risk management in the private sector are still in place, as can be seen from the numerous heads that have rolled because of the recent market fallout.

7   To me, the more pertinent issue is a hazard of a different kind, and I am not sure if it is moral or otherwise. This hazard is the potential loss of effectiveness of financial authorities’ policy tools. A central bank clearly has a case to intervene if a crisis threatens its objective of financial stability, however in doing so, it should avoid creating expectations that may undermine its effectiveness in future crises. In many, if not all crises, the management of sentiment and expectations are just as important as the management of fundamentals. Under “business as usual” conditions, predictable and consistent policy actions are the best facilitator, but ironically in times of crisis, financial authorities may need to have a more varied array of policy options so as to retain the ability to “shock and awe.”

8   In order to remain effective, central banks need to have a variety of tools at their disposal. In light of recent events, one current issue worth considering is for central banks to expand the range of acceptable collateral. While valuation difficulties may present some challenge, such an option would allow central banks more leeway to tailor their response to a crisis. Additionally, central banks may even have to consider developing instruments tailored not just for their domestic markets, but which also accommodate foreign markets that their institutions operate in.

9   Apart from an arsenal of crisis management tools, the enhancement of preventive tools is also important to aid in risk detection and mitigation. Furthermore, central bankers and supervisors need to continually upgrade their skills so as to keep up with latest market innovations.

Effective Regulation Requires Cooperation

10   Cooperation amongst regulators is also crucial as markets become more complex and global. While no one denies that financial innovations have many positive uses, some of which actually reduce risk, the misuse of these new fangled instruments can also mean that risks are obscured and transferred to less well-informed investors in an unsavoury manner. As many of these risk transfers occur across geographical borders, home and host regulators need to engage in greater dialogue and collaboration in order to gain a better picture of systemic risks that could affect a broad range of market participants.

11   At this point, I would like to acknowledge the sharing by US and European financial authorities of their experiences and supervisory information regarding the impact of the recent subprime crisis. For host regulators such as the MAS, such forthcoming cooperation has been very useful in helping us discharge our supervisory responsibilities. I hope that this exchange of information between financial authorities will continue to strengthen so that system-wide problems can be more effectively dealt with. Better collective understanding and cooperation among regulators are essential in managing risk of a global financial institution.
Allow me now to touch briefly on the effect of the subprime crisis on Asia.

Effect of the Subprime crisis on Asia

12   Generally speaking, Asian financial systems are much less securitised than the US or European markets, and thus have been less affected by the recent turmoil. Asian holding of US mortgaged-backed securities (both subprime and otherwise) amounted to about 1% of banking assets in Asia. However, Asia was not entirely unscathed.

13   The month of August saw a significant widening of Asian sovereign spreads coupled with a fall of Asian currencies and a sell-off in the Asian equity markets. Yet risk aversion in Asian financial markets abated fairly quickly. Once bitten, twice shy. I believe that one of the major reasons for Asia’s resilience is the experience of the Asian Financial Crisis, which continues to reside in the collective consciousness of the region. Asian financial institutions are much stronger today than ten years ago when the Asian crisis unfolded. The Asian markets are now deeper and investors are much more cognizant of possible downside risks. There has also been a substantial build up of foreign reserves across the region which underlies a systemic effort to reduce vulnerabilities. Another reason Asia was less affected was because banks were still getting decent returns from the more traditional deals in recent years without having to do as much searching for yield in the universe of more esoteric instruments.

14   Asia has thus far weathered the sub-prime crisis well and fundamental growth prospects remain generally sound as there are now more growth engines in the region. Most Asian economies also run current account surpluses and have built up a cushion of foreign reserves over the years. Nonetheless, caveats still remain. The biggest risk to the region’s macroeconomic outlook remains a sharp downturn in the US economy as Asia is still highly dependent on exports. In addition, the Asian region would continue to face challenges associated with large capital inflows such as the impact on exchange rates, asset prices and credit growth. The recent sharp increase in oil prices would also lead to some inflationary pressures, thus posing further challenges to policy-makers.

Conclusion

15   On a day to day basis, financial authorities have the responsibility of ensuring the efficient functioning of the necessary infrastructure to facilitate orderly capital flows. In order to effectively discharge this duty, financial authorities need to be proactive in identifying emerging risks so as to be able to develop strategies to mitigate them. Central bankers in particular need to develop and refine a variety of tools in order to act decisively in times of stress. Furthermore, close cooperation amongst regulators will aid the early detection of problems and better facilitate the coordination of efforts in the event of a global financial crisis.

16   The events in recent months hold many important lessons for the financial community, and to a large extent, we are still in the midst of the learning process. Yet in thinking about how to prevent a similar crisis in the future, we must be careful not to let the regulatory pendulum swing too much to the conservative, as stifling markets will not make them healthier. The first line of defence should always be the financial institution’s own internal risk management process, and it is the ultimate responsibility of senior management and the Board to ensure that the risks are understood, correctly assessed and within acceptable parameters. As such, I would like to acknowledge the work done by banks in Europe and international organizations such as the IIF , in fostering self-awareness amongst the banking community by identifying current weaknesses and recommending best practices for the industry.

17   Thank you for your kind attention.