Financial Reform: Need for Inclusive Finance

November 22, 2012

by HRH Dr. Raja Nazrin Shah@http://www.nst.com.my

NEARLY half a decade has passed since the beginning of the global financial crisis. However, the world economy has yet to fully recover, with many nations still faced with significant challenges. These include the ability to sustain a momentum for growth and a need to develop and implement wide-ranging structural reforms to put their economies and financial systems on a sounder footing.

But what ought to be the focus of these reform efforts? Over the last few years, much has been said and written about the role of financial institutions in precipitating the economic malaise we are currently facing. However, to narrow attention on individual entities would be to repeat the mistake of the past. If recent events have taught us anything, it is that the individual entities which make up the financial system do not live in splendid isolation, and that financial instability can come about from a host of factors.

In formulating a holistic solution, due regard should be paid to macro-level interplays amongst agents and constraints within the system. Here, this forum’s focus on the financial ecosystem is not only most timely but also useful — useful in that the concept gives us a ready means to frame the problems we encountered and hopefully to find better ways of solving them.

Allow me to briefly touch on a few important concepts relating to the notion of an ecosystem and draw some analogies to the financial space. I will then propose a number of ecological principles which I believe can be applied to this space and can help us in our efforts to revitalise the global financial system.

An Ecological Framework

The first concept is that of an ecological community, that is an assemblage of two or more populations of different species occupying a shared environment. We can think of an ecosystem as a network of interactions within this community itself, and with the environment it occupies. The economic analogue to this was identified by James Moore, previously of Harvard Law School, who came up with the notion of a business ecosystem as: “An economic community supported by a foundation of interacting organisations and individuals — the organisms of the business world. The economic community produces goods and services of value to customers, who are themselves members of the ecosystem. The member organisms also include suppliers, lead producers, competitors, and other stakeholders.”

We can think of a financial ecosystem in a similar way, as an economic community comprising users and providers of financial services, intermediaries and regulators, operating within an environment which includes the real economy and shaped by the prevailing laws, customs and government policy. And just as the sum of all natural ecosystems is called the biosphere, we can think of the financial ecosystem as one of many interconnected socio-economic ecosystems which constitute the econosphere.

Dr. Moore used various metaphors from ecology in describing how this ecosystem worked, including the notion of co-evolution by organisations and individuals, especially when a particular niche that a business occupies is challenged by the arrival of new species.

This means that companies need to become proactive in developing mutually-beneficial, or symbiotic, relationships with customers, suppliers, and even competitors.

This brings me to the second set of concepts, that of biodiversity and mutualism. Biodiversity plays an important role in ecosystem functioning for several reasons. But perhaps one of the most crucial is that an abundance of diverse species means a higher chance of an organism being able to draw some form of mutual benefit from others. Pollination, for instance, is a classic form of such mutualism. What this suggests is that an ecosystem stands to gain from being more inclusive than competitively exclusive.

Here too the financial analogies are many. For instance, a large number of investors, with a diverse set of views and freedom to enter and exit, are the basis for liquid markets and the more efficient valuation of securities. But there is also the notion of inclusiveness in the delivery of financial services, at affordable costs, to sections of disadvantaged and low income segments of society. Such access is now thought to be an essential element of an open and efficient society.

An ecosystem’s functioning need not come about from the interaction of numerous small entities of course. In many cases there are so-called “keystone” species, whose effect on the ecosystem is disproportionate to their abundance. For instance, the Acorn Banksia tree in Western Australia is the sole supplier of nectar for the Honeyeater bird species, whose role in turn is crucial in the pollination of the region’s numerous plant species.

The equivalent in a business ecosystem would be leading companies whose role is valued by the community because it may enable members to move toward shared visions to align their investments, and to find mutually supportive roles. But as we know such munificence is not guaranteed: the centrality of such entities means that an upset in the balance they provide can also have a disproportionately adverse effect on the ecosystem. In current parlance, such entities could be regarded as too big to fail.

Such interactions between species shape the third concept to which I now turn, that is the complex dynamics of ecosystems. Ecosystems are dynamic: they are subject to periodic disturbances and are forever in the process of recovering from some past disturbance. When an ecosystem is subject to some sort of perturbation, it responds by moving away from its initial state. The tendency of a system to remain close to its equilibrium state is known as its resistance. On the other hand, the speed with which it returns to its initial state after disturbance is called its resilience.

Likewise episodes of instability also beset a financial ecosystem, the health of which is measured by how well it absorbs shocks and is able to continue performing its function of directing real resources to their ultimate use. This encompasses not just the intermediation of funds and a mechanism for making payments; it also includes less tangible, but no less important, roles of providing liquidity, a means for hedging and a way of dealing with informational imbalances. For a financial ecosystem to display strong resistance and resilience, its various components must work together, in particular to improve the information available to guide resource allocation.

I believe the recent crises are a manifestation — the symptoms, if you like — of an ailing financial ecosystem. For example, having framed the issue through the lens of ecology, we can argue that the ultimate goal of the financial ecosystem is to ensure its overall sustainability, not the survival of any one species over another. This implies that, under certain circumstances, the ecosystem’s viability may only be sustained by allowing certain ailing institutions within it to fail. A healthy ecosystem should be robust enough to not be fundamentally affected by individual failures. This was clearly not the case within the existing global financial ecosystem.

A way forward, therefore, is to consider a holistic approach, which attempts to achieve the benefits of mutualism and inclusion, through diversity and the presence of keystone entities, while building in greater resistance and resilience to what appear to be the prospect of more frequent systemic perturbations.

But to find a remedy, we must first diagnose the malady. An examination of recent developments in the global financial system, particularly the Great Financial Crisis, can offer a number of important lessons.

The crisis was striking both in magnitude and reach. It began as a cluster of mortgage delinquencies in the United States which appeared, at the time, to be wholly containable. What originated as a singular pathogen rapidly mutated into a virulent strain which spread throughout the global financial system.

The resulting collapse in institutions and asset prices dramatically affected both corporate and household wealth. The value of individual investments and retirement savings was eroded. Jobs were lost and growth decelerated into stall speed. Governments had to play the role of paramedic and stepped in to provide emergency assistance to businesses deemed too big to fail. This assistance was not without cost. Every billion spent to support the financial sector was a billion of forgone investments in infrastructure, education and other form of public goods and services.

It was thus that a crisis which had its genesis in the financial system eventually affected the health of the real economy, creating a climate of uncertainty and paralysis. The estimated output gap in the world’s major economies remains as high as 2.5 per cent of GDP in the Euro area and Japan, and 4 per cent  of GDP in the US.  This amounts to hundreds of billions of dollars’ worth of output loss. Today, the unemployment rate in the world’s major economies remains high, ranging from 7.9 per cent  in the US to more than 11.6 per cent in the European Union.

Moreover, the Great  Financial Crisis  was also essentially a crisis with no clear, singular culprit. On the whole, key actors appear to be guided more by the desire to respond rationally to prevailing incentives, rather than a deliberate intention to harm. The crisis thus embodied a classic fallacy of composition.  Actions that may have made sense at an individual level, when interplayed with the decisions of other players within the financial system, led to an outcome that was greatly destabilising.

Hence, the risks to which the financial system was exposed were greater than the sum of their parts — a consequence of the relatively narrow prism through which we viewed the financial sector before these risks crystallised. With the benefit of hindsight, we have come to recognise the need to monitor, mitigate and manage systemic risk. This understanding should be expanded and applied in a holistic manner, to ensure that we could successfully rebuild the system and regain the trust lost in recent years.

Principles for building a more inclusive and dynamic financial ecosystem

It is increasingly recognised that greater dynamism and inclusiveness are essential pre-conditions for a healthy financial ecosystem. These issues are being raised at the highest level amongst multilateral institutions and policymakers. In a lecture delivered during her visit to Kuala Lumpur last Wednesday, Christine Lagarde, Managing Director of the IMF, highlighted that inclusiveness should be one of Asia’s key policy objectives in charting its future growth.

The World Bank also recognises the need for inclusiveness, and I quote: “Inclusive financial systems allow poor people to smooth their consumption and insure themselves against economic vulnerabilities.  Financial access enables poor people to save and to borrow — allowing them to build their assets, to invest in education and entrepreneurial ventures, and thus to improve their livelihoods. Inclusive finance is especially likely to benefit disadvantaged groups such as women, youth, and rural communities.”

It is clear that healing the financial ecosystem to make it more dynamic and inclusive is an important first step towards restoring equilibrium within the broader economy. I would like to offer a few insights from an ecological perspective on what a healthy financial ecosystem could look like. I hope that this perspective would enrich the debate surrounding this issue.

First, all constituents within the financial ecosystem should have due regard for their ecosystem and the broader ecosphere.

The constituents I am referring to are the diverse groups of separate, yet interdependent, organisations and individuals which populate the financial ecosystem, all of which are essential to it working effectively. These entities include not only financial sector components such as intermediaries, markets and infrastructure.

The issuers of securities, those who invest and trade in them, custodians, advisers, information providers — even regulators — are all part of the financial ecosystem.

But as I mentioned earlier, this ecosystem can be thought of as being part of a wider econosphere — the socio-economic environment in which we all exist. Stakeholders of the financial ecosystem are therefore far more wide-ranging than its immediate participants. They include individuals and firms whose livelihoods could be threatened if the excesses of the financial sector jeopardises the real economy, as we are seeing around us at the moment. It includes future generations, who will have to forgo a portion of the fruits of their labour to pay off the debt created today.

The financial ecosystem can no longer afford to ignore the spillover effects of its actions. To borrow an idea from President Barack Obama, the financial ecosystem can only work when it accepts certain obligations to one another, and to future generations.   This respect for mutual obligations should be held in equal importance with the assertion of individual rights. This sense of responsibility towards the broader society and the future generation can help to introduce a more moderate, holistic and long-term approach in decision-making within the ecosystem.

To achieve this change, the rules of the ecosystem should ensure that ethical behaviour is rewarded and unscrupulous actions are penalised. Information asymmetries should not be exploited to boost revenue by selling consumers products that are clearly unsuitable for them. Firms and individuals should no longer be able to justify unethical behaviour that complies with the letter but not the spirit of the law.

Regulators and policymakers should be more willing to make difficult decisions to correct excess and exuberance when they begin to appear. The existing system should be restructured where necessary to halt the socially damaging privatisation of gains and externalisation of losses.

This increase in regulatory discipline should be met by heightened self-discipline. There needs to be a conscious and genuine effort to instil ethics and social responsibility among all players within the system.

Decisions should be driven by the need to do the right thing, not just to do things right. The growing trend in various forms of ethical investment, such as Islamic financial products and socially responsible investing, should be further encouraged.

A more inclusive financial ecosystem would also make available products and services that cater for segments of the population that are currently underserved because of their low profit margins. These include low-income households, women in jurisdictions where the right to own and dispose of property is traditionally assigned to men, as well as start-up companies and small- and medium-sized enterprises. Barriers to entry as well as the costs of accessing loans and savings products should be lowered.

In Asia, there remains scope for improvement in terms of financial inclusiveness. Despite its sizable current account surpluses, it is interesting to note that investments by Asians within Asia remain relatively low. For example, more than 90 per cent of ASEAN cross-border portfolio investment flows take place with advanced economies located outside of Asia. A realignment of such flows to ensure that Asia’s high savings could help to further invigorate regional consumption and investments could further improve the dynamism and inclusiveness within Asia’s financial ecosystem.

At a more basic level, despite tremendous growth, almost half of all adults in East Asia and the Pacific still do not have an account at a formal financial institution, and are hence excluded from the financial system. Barriers include not only poverty but also the costs of opening and maintaining an account, and the distance to the nearest financial institution.

Without affordable access to financial products and services, lower-income households and smaller businesses face significant constraints in consolidating their wealth and financing productive ventures.

Another important component of Asia’s social safety net is the adequacy of pension and unemployment insurance coverage. In the past, elderly Asians have traditionally relied on their children to provide for their material needs. However, socioeconomic changes brought about by Asia’s rapid growth — such as urbanisation and industrialisation — have resulted in smaller nuclear families that are less conducive to intra-family support.

In emerging Asia, only 20 per cent of the working population is covered by pension and unemployment insurance schemes, compared to 60 per cent in the OECD. Such an arrangement does not appear to be sustainable, given the projected demographic transition to fewer babies and longer lives.

Recent initiatives undertaken by Malaysia could serve as examples of how these issues may be addressed.Earlier this year, the Securities Commission launched the voluntary, long-term private retirement scheme (PRS) which was designed to help individuals accumulate savings for retirement. The PRS will operate alongside the Employees Provident Fund (EPF) and complement the mandatory contributions made to EPF.

Efforts by Bank Negara Malaysia to encourage the provision of mobile banking services also would further promote financial inclusion, particularly among users living in rural areas.

The proliferation of such products might mean lower profits for the financial sector in the near future. However, providing financing to these consumers is likely to improve their earning potential, particularly if it is used to fund productive ventures. The resulting expansion in economic activity — which financing helped make possible — is likely to open new avenues of business for the financial sector.

Regulators and policymakers would benefit from encouraging regulated providers of financial services to cater to underserved market segments. This would reduce the incentive for constituents of those segments to seek financing solutions from outside of the regulated system, which could result in abusive lending practices and the rise of the shadow banking sector.

Financial intermediation which takes place beyond regulatory oversight could lead to a build-up of unmonitored risks, which have destabilising implications. Therefore, by aligning the incentives of players within the financial ecosystem and those in the real economy, we can help to ensure that the symbiotic relationship amongst them can continue to be mutually beneficial.

Second, a healthy financial ecosystem should aim to optimise, not maximise, the financial sector. A well-functioning financial system can reduce transaction costs, facilitate investment and improve the distribution of capital and risk across the economy. Optimisation requires the financial ecosystem to respect the constraints imposed upon it. More specifically, it requires the recognition that there is an upper limit to growth —  beyond which further expansion could be destabilising. Optimisation strategies allow for a stable equilibrium to be maintained within the system, which promotes certainty.

Within the context of the financial ecosystem, to optimise means to expand and profit only up to the level that is necessary for the greater good of the entire economy. This requires a recalibration in the mindset of every entity within the ecosystem. The primary motivation behind every action should not be to maximise the ecosystem’s own gains, but to preserve the viability of the overall econosphere.

It is important to note that I am not arguing against growth in the financial sector per se. Rather, for such growth to be sustainable, it must happen in tandem with growth in the real economy. The profits which power such growth in the financial sector also should be derived from activities that deliver “real” benefits to the economy, as opposed to products and services that are more speculative in nature and cause the financial system to become more vulnerable to shocks.

Third, the resilience of the financial ecosystem should be  monitored and assessed continuously and the design of policies and regulations must be proactively gauged against its prevailing health.

This may sound like an obvious goal, but it is in fact more complicated than first appears. One issue relates to the nature of resilience itself. Policies will have to address a number of issues, including: How easy or difficult is it to change the system; that is, how “resistant” is it to being changed? What is the maximum amount a system can undergo change before losing its ability to recover? Such “latitude” implies a threshold which, if breached, makes recovery difficult or impossible. And how close is the current state of the system to this limit? In other words, is it in a “precarious” state?

Policies would also have to address what ecologists call “panarchy”, that is the degree to which a certain hierarchical level of an ecosystem is influenced by other levels. For example, organisms living in communities that are in isolation from one another may be organised differently than the same type of organism living in a large continuous population. As a result, the overall community is influenced by population-level interactions.

This was clearly the case in the US mortgage-securities market, which consisted of a hierarchy of housing borrowers, mortgage brokers, originators, arrangers and issuers, credit rating agencies, trust companies and special purpose vehicles and, ultimately, end-investors in mortgage-backed securities. Each layer was organised in a way that added more risk to the system: mortgage brokers were encouraged to sell as many mortgages as possible, given that these were in demand by originators; originators in turn were not concerned about individual credit quality given that these were being pooled into structured securities; end-investors bought such products on the basis of ratings; and so on, with the resultant panarchy being exacerbated by information gaps between each layer.

In thinking about resilience, some have begun to question the free-market model within which global markets have been operating. They suggest the very act of specialisation, on which market efficiency and productivity is based, weakens resilience by permitting systems to become accustomed to and dependent upon prevailing conditions. In the event of unanticipated shocks, this dependency reduces the ability of the system to adapt to these changes.

What these issues imply is that as with the natural environment, financial resilience cannot be achieved effectively through one-size-fits-all policies. This would mean making the extent and degree of certain financial activities scalable, the size of which at any time would depend on whether the system were reaching its resilience threshold. What is allowed or how decisions are made would have to take into consideration the prevailing health of the financial ecosystem.

Regulation and policies would have to explicitly refer to systemic resilience and thresholds, which in turn would have to be defined. This is not an easy thing to do and will require significant investment into research associated with systemic risk and financial stability at both the global as well as local level, in much the same way scientists have focused on ecological resilience.

Conclusion

We are certainly standing at an important juncture for both the global financial system as well as the economy. Events which transpired within the last few years have provided us with impetus to reform the structure of the financial ecosystem, with a view to promoting sustainable and equitable growth both within the financial sector and the real economy. It is important for us to apply the lessons learnt over recent years to avoid repeating the same mistakes, even as we navigate new challenges ahead.

In moving forward, we must remember that certain actions taken by firms and individuals within the financial ecosystem may be individually rational. However, when viewed collectively, the outcome of these actions may be detrimental to the system as a whole. In monitoring for potential build-up of such systems risks, there needs to be a constantly vigilant pair of eyes on the big picture, which is the entire ecosystem.

Regulatory and policy responses also should focus on strengthening the resilience of the ecosystem, to ensure that actions taken by individual entities do not jeopardise the entire econosphere. A resilient and healthy ecosystem should have two important characteristics: dynamism and inclusiveness. Dynamism is necessary to ensure that the ecosystem is resilient, which is necessary for sustained economic viability of not only the current but also future generation.

As for inclusiveness, it is interesting that the origin of the prefix “eco” in ecosystem comes from the Greek word for “home”. An exclusive financial ecosystem is one which has no place for many individuals and firms. Such an ecosystem is neither sustainable nor fair.

The remarks delivered by International Monetry Fund Managing Director Christine Lagarde in Kuala Lumpur echo these sentiments: “In a more integrated world, it is sometimes too easy for people to get lost or forgotten. In such a world, it becomes even more important to make sure that growth benefits everybody and that vulnerable people are protected — and included.”

The dynamic and inclusive financial ecosystem which we aim to build should be one that has a “home” for everyone, including the most vulnerable within our society. Only such an ecosystem could support equitable and sustainable economic growth by capturing the benefits of diversity and mutualistic interaction, while promoting resilience and stability.

Keynote address by  Raja  Muda of Perak Raja Dr Nazrin Shah  at the Asian Finance Forum 2012