High Performance Financial Systems: Blueprint for Development 9789814379205

Table of contents :
Contents
List of Tables
List of Figures
1. Introduction
2. Stylized Process of Financial Intermediation
3. Strategic Positioning of Financial Services Firms
4. Sources of Competitive Advantage
5. Financial Institutions: Strategies and Performance
6. Regulatory Determinants of Financial Structures
7. Banking Structure and Industry Linkages
8. Economics of International Financial Centres
9. Calibrating Financial Systems: The Case of Singapore
10. Conclusions
Notes
References
The Author

Citation preview

High Performance Financial Systems

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The Institute of Southeast Asian Studies (I SEAS) was established as an autonomous organization in 1968. It is a regional research centre for scholars and other specialists concerned with modern Southeast Asia, particularly the many-faceted problems of stability and security, economic development, and political and social change. The Institute is governed by a twenty-two-member Board of Trustees comprising nominees from the Singapore Government, the National University of Singapore, the various Chambers of Commerce, and professional and civic organizations. A ten-man Executive Committee oversees day-to-day operations; it is chaired by the Director, the Institute's chief academic and administrative officer. The ASEAN Economic Research Unit (AERU) is an integral part of the Institute, coming under the overall supervision of the Director who is also the Chairperson of its Management Committee. The Unit was formed in 1979 in response to the need to deepen understanding of economic change and political developments in ASEAN. A Regional Advisory Committee, consisting of a senior economist from each of the ASEAN countries, guides the work of the Unit.

ISEAS Current Economic Affairs Series

INGO WALTER

High Performance Financial Systems

··--·----

Blueprint for Development

1~111!!!

ASEAN Economic Research Unit

glii.lliil INSTITUTE OF SOUTHEAST ASIAN STUDIES

Published by Institute of Southeast Asian Studies Heng Mui Keng Terrace Pasir Panjang Singapore 0511 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the Institute of Southeast Asian Studies. © 1993 Institute of Southeast Asian Studies

The responsibility for facts and opinions expressed in this publication rests exclusively with the author and his interpretations do not necessarily reflect the views or the policy of the Institute or its supporters. Cataloguing in Publication Data Walter, Ingo. High performance financial systems: blueprint for development. (I SEAS current economic affairs) 1. Finance. 2. Finance - Singapore. 3. Banks and banking. 4. Banks and banking- Singapore. I. Title. II. Series. DS501 I599C 1993 1993 sls93-67817 ISBN 981-3016-64-7 ISSN 0218-2114 Typeset by Superskill Graphics Pte Ltd Printed in Singapore by Prime Packaging Industries

Dedicated to the merrwry of Professor KS. Sandhu Director of !SEAS, 1972-1992

Contents List of Tables

ix

List of Figures

xi

1.

Introduction

1

2.

Stylized Process of Financial Intermediation

5

3.

Strategic Positioning of Financial Services Firms

31

4.

Sources of Competitive Advantage

39

5.

Financial Institutions: Strategies and Performance

45

6.

Regulatory Determinants of Financial Structures

51

7.

Banking Structure and Industry Linkages

57

8.

Economics of International Financial Centres

77

9.

Calibrating Financial Systems: The Case of Singapore

87

10.

Conclusions

113

Notes

116

References

117

List of Tables ~-----~

2.1

Share of Financial Assets of Selected U.S. Domestic Financial Institutions

16

2.2 Securitized Asset Classes

20

2.3 Derivatives Volume

24

International Market Wholesale Banking and Investment Standings, 1992

49

7.1

Summary of Bank-Industry Crosslinks

65

7.2

Mapping of Bank-Industry Crosslinks and International Market Access

74

5.1

7.3 Possible Convergence in Banking Structures and Corporate Control Systems 9.1

Financial System: Benchmarking

9.2

Financial System: Five-Year Time Frame Benchmarking

75 90 110

List of Figures 2.1

Intermediation Dynamics

2.2

Efficiency in Financial Intermediation

7 11

2.3 U.S. Commercial Paper Outstanding, 1980-93

17

2.4 Assets of Money Market Mutual Funds, 1972-93

18

2.5 Household Financial Assets

21

2.6 U.S. Privately Placed Debt

22

2.7 Securities Market Infrastructure Services

26

2.8 Financing Alternatives Available to Major Corporations

28

2.9 Investor Services in the Modem Financial System

29

3.1 The Competitive Opportunity Set

33

Returns for Entry into a New Market

34

7.1 Alternative Corporate Control Structures

60

7.2 Prototype Bank Organization Structures

63

Stock Market Turnover as Percentage of Market Capitalization

103

SIMEX Annual Volume and Open Interest, 1984-92

106

3.2

9.1 9.2

1 Introduction

2

High Performance Financial Systems

E w issues are more important in setting the agenda for economic growth than the structure, conduct and performance of a nation's financial system. Standing at the centre of the transactions and resource allocation process, high performance financial systems are increasingly important as determinants of sustainable economic progress and stability. This is as true domestically as it is internationally. National financial systems require an efficient "window" on global sources and uses of capital, as well as market developments and financial technologies that change in substance and form at a rapid pace. Few countries can afford to be isolated from these developmentsespecially as they develop mature industrial structures and rapidly evolving services sectors-or fail to create and maintain domestic financial systems that can eventually meet world performance standards. This study outlines the framework of high performance financial systems and the parameters for financial firms operating in them. We begin with an intuitive structural model of financial intermediation, and discuss the various stages of its evolution in terms of static and dynamic efficiency characteristics. We then consider issues facing players in, and users of, the financial system. We emphasize strategic positioning alternatives facing banks and other types of financial institutions, and the principal determinants of their competitive performance. This includes the critical role of regulation as a major factor affecting the performance of the financial system itself, both in the context of national economic growth and competitiveness, and as a factor in defining the future of various types of financial firms. The study also deals with a critical and controversial dimension in the design of the financial system, that is the relationship between the structure of financial institutions, and the linkages to ownership and the control process in industry. How countries deal with this issue can have dramatic effects on both the financial system and the fundamentals of industrial performance.

Introduction

3

In the final two sections of the study we apply the lessons of the economics of financial system performance to the battle among financial centres, both in terms of retaining domestic financial flows and attracting foreign ones, and calibrating national financial systems against a set of benchmarks derived from the analysis. We use Singapore as a case study in this connection.

2 Stylized Process of Financial Intermediation - - - - - -

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6

High Performance Financial Systems

h e central component of any model of a modern financial system is the nature of the conduits through which the financial assets of the ultimate savers flow to the liabilities of the ultimate users of finance, both within and between national economies. This involves alternative and competing modes of financial intermediation, or "contracting" between the parties in financial transactions. In this section, we shall discuss the intermediation framework in terms of a model that can be useful in making defensible prognoses of structural shifts in national and global banking and financial markets through time. A convenient model that can be used to guide thinking on financial contracting and the role of financial institutions and markets is summarized in Figure 2.1. The diagram depicts the financial process (flow-of-funds) among the different sectors of the economy in terms of underlying environmental and regulatory determinants or drivers as well as the generic advantages needed to profit from the three primary intersectorallinkages: • • •

Savings/commercial banking and other traditional forms of intermediated finance. Investment banking and securitized intermediation. Various financial direct-connect mechanisms between borrowers and lenders.

Ultimate sources of surplus funds arise in the household sector (deferred consumption or savings), the corporate sector (retained earnings or business savings) and the government sector (budgetary surpluses). •

Under the first or "classic" model of financial intermediation, savings (or funds-sources) are held in the form of deposits or alternative types of claims issued by commercial banks, savings organizations, insurance companies or other forms of financial institutions entitled to finance themselves by placing their liabilities directly with the general public. Financial institutions then use these fund flows (liabilities) to purchase domestic and international assets issued by non-financial institution agents such as firms and governments.

FIGURE 2.1 Intermediation Dynamics

JWo:tmation adw,tntages Interpretaqfonnation (forwards, futures, options) I o~~tion I

[

f

Securities new issues [

Loans & advances

I.

....c;

Market~making

t

• •

•

. .

I

. I .

Secun.t.1es _____ _ I ·Collective . t men t s ;: ~ mvestment mves vehicles

•

Secunt.les. d.·ea.l.ers. (B)

I Iinan::::

ro [j)

,......., [j)

>::::

10

200

~

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[j)

150 Q)~ ....,

'-' Q)

8;:j

~

5

..c: ...., '-' ...., .;::i

6,270,927 • 5,720,610

>::::

Q)

5

100

50

0

1984 1985 (Jul-Dec)

1986

1987

1988 Year

1989

0 1990

1991

1992

8

Calibrating Financial Systems: The Case of Singapore

107

Although all financial institutions in Singapore are regulated by MAS, they are regulated under different legislation according to the institution type and activities undertaken. The activities of commercial banks are governed by the Banking Act while those of finance companies come under the purview of the Finance Companies Act. The Banking Act was based on the banking legislation of the United States and Switzerland. Securities firms are regulated under the Securities Industry Act, modelled after similar legislation in Australia. Futures trading companies in Singapore are regulated by the Futures Trading Act, modelled after the U.S. Commodities and Futures Trading Commission's Commodity Exchange Act. Separate departments within MAS supervise the financial institutions under the appropriate Acts. As a result, the regulation of financial institutions in Singapore is considered by MAS to be effectively under different agencies, and similar to the American multi-agency system of supervision. Housing all the agencies in MAS ensures that the authorities are better able to co-ordinate supervision of the financial institutions, and permits supervision on a consolidated basis more effectively-as well as keeping up with changes in the financial market structure. In Singapore, the U.S. system is considered as having lagged in keeping up with such changes in some areas, a "failure" which nonregulators consider to be visible evidence of one of its greatest strengths, the freedom to create and sometimes to fail. In the commercial banking sector, MAS administers the Banking Act via guidelines and qualitative reserve and liquidity ratios, selective licensing on safety and soundness criteria as well as contribution to the financial system, periodic review and supervision based on on-site examinations, call reports and examinations by external auditors, which in effect form an integral part of the regulatory apparatus. Implementation of guidelines and the bank supervision process itself appear to be highly rigorous and detailed. Besides regulating the fitness and properness of banks, securities firms, finance companies and insurance companies, MAS also has oversight responsibilities for the conduct of business on the SES Main Board and SESDAQ. MAS checks for abuses

108

High Performance Financial Systems

such as insider trading, market discipline, listing rules, securities fraud and anticompetitive practices. The self-regulatory structure under strict MAS supervision appears designed to optimize the balance between an arm's length external regulator and the role of market practitioners in the regulatory process. SIMEX is likewise regulated with respect to both licensing of market participants and conduct of business by its membership under MAS oversight in accordance with the 1986 Futures Trading Act. The Monetary Authority is clearly pro-active in its approach, and many of the major developments in Singapore's financial services sector were the result of systematic MAS initiatives rather than market dynamics. However, there is no regulatory competition, and no particular room domestically for marketdriven creativity beyond the local introduction of financial product- or process-innovations that have already proved themselves elsewhere-after careful vetting by the MAS gatekeeper. This has almost certainly contributed to the financial system's record of stability. Whether it is the optimum structure for a financial centre operating closer to the frontiers of the banking and securities industry in regulatory competition with both regional and global financial markets remains to be seen. MAS would challenge this conclusion by pointing out that Singapore has become the world's fourth largest foreign exchange trading centre, with net average daily volume of US$76 billion in 1992. Membership in SIMEX grew from 205 in 1986 to 489 in 1993, with the average daily volume increasing from 3,000 lots to 54,000 lots over the same period. Continued innovation increased the variety of futures contracts in SIMEX from four in 1986 to 11 in 1993 and resulted in SIMEX being awarded "International Exchange of the Year" honours in 1992 by the International Financing Review, a U.K.-based publication. While the volume of bank loans syndicated totalled S$45 billion over a decade, the Asian Dollar Market kept pace with the growth in complexity of the financial needs of the region through the introduction of more sophisticated products and services such as note issuance facilities (NIFs), revolving underwriting facilities (RUFs) and various new securitized

Calibrating Financial Systems: The Case qfSingapore

109

instruments. Meantime, financial institutions in Singapore have turned in healthy performances in recent years, with aggregate net profit before tax (NPBT) growing by 26 per cent annually from 1986 to 1992 (even more for full-licence foreign banks). Singapore continues to be an attractive financial centre as evidenced by the 129 commercial banks and 76 merchant banks from 34 countries operating in the country, and its development into the world's fourth largest foreign exchange trading centreeven as SIMEX has developed into an international futures exchange that has attracted 81 futures companies to set up their operations in Singapore, adding to the depth and scope of activities of its financial centre. The counterarguments of MAS clearly have substantial merit in light of the track record so far. It begs the question whether things would have gone even better, or possibly worse, with a somewhat less heavy regulatory approach in recent years. The central issue is whether the successful approach of the 1980s will serve the country equally well in the year 2000. Despite protestations of confidence and occasional flashes of arrogance, one senses among the authorities a certain level of unease in discussions of this critical issue.

Summary We can conclude this discussion by attempting to "benchmark" Singapore's financial system, described briefly here, against the criteria listed in Table 9.1. These are presented in Table 9.2, providing only ratings of Excellent, Good, Average and Poor. Clearly these are highly subjective and tentative in nature and hence debatable. Still such benchmarking may be a useful exercise, if only as a reality check for those engaged in the financial services industry and those responsible for determining its future course. In effect, Singapore runs a "bi-modal" financial system, intended to be world-class competitive for offshore transactions yet heavily dirigiste domestically. The question is how long this approach can be sustained in light of the financial services

TABLE 9.2 Financial System: Five-year Time Frame Benchmarking 1. Domestic performance criteria Competitive markets and static efficiency Cost structures/x -efficiency Risk management Excess returns Potential for economies of scale and superscale Potential for economies of scope Structural forms likely to be exploited Universal banking High-performance specialized banking Multi-capacity financial congenerics Market-driven dynamic efficiency Financial products Financial processes Macroeconomic resource configuration impact Capital cost and allocation (static) Structural adjustment (dynamic) International competitiveness implications For local financial services firms For the (downstream) real sector 2. External attributes: financial centre economics Economics of functional centres Growth Stability Industrial base Trade and foreign direct investment Infrastructure

poor poor poor good good good average poor poor average average poor poor average

excellent excellent average excellent excellent

Cost base Labour force Capital market transparency Capital market liquidity Financial market entry and contestability Agglomeration economies Net regulatory burden CentrifugaVcentripetal forces Economics of booking centres Tax-driven Regulation-driven Stability-driven Confidentiality-driven FunctionaVbooking composites 3. Local banks' performance abroad: Positioning and performance Retail banking abroad Private banking abroad Middle-market commercial banking Wholesale commercial banking Capital markets Primary markets Secondary markets Derivatives Corporate finance Investment management Institutional Private clients

* In contiguous regions only.

good good poor poor poor good poor good good good excellent good good

good* average good poor poor poor poor poor poor poor poor average

112

High Performance Financial Systems

industry's identification as a major source of next-generation growth for the economy as a whole. The foregoing informal benchmarking, taking a five-year time frame from 1993, suggests some evident areas of strength in the underlying performance of the real sector, infrastructure development, political stability, human resources quality, and tax treatment, but weaknesses in the all-in cost of domestic financial intermediation, the state of development of domestic financial markets and the positioning of Singapore banks in the broader international environment. It suggests that the financial system of Singapore continues to be retarded by limits to effective domestic competition and pervasive regulation based on a degree of conservatism that may have outlived its undoubted past usefulness. It may thus require some recalibration to make possible the goal of the financial sector as one of the nextgeneration growth-engines of the Singapore economy.

10 Conclusions

114

High Performance Financial Systems

In this study, we have considered a basic model of financial intermediation, the static and dynamic efficiency and stability attributes that define its value in the context of economic development and the national interest, and the implications for the financial firm in terms of strategic positioning and performance. We have also considered the relationships that appear to exist between the banking and financial structure and the process of corporate governance and control, including their implications for economic performance. And we have considered some of the difficult issues and tradeoffs facing regulators as they strive to maximize the efficiency, competitiveness and stability of the national financial systems in a global environment where not only financial firms compete with one another, but regulators do so as well. Prospective developments in global financial markets carry serious implications for both national financial systems and for the various strategic groups of firms competing for business, and much reshuffling of clients and suppliers can be expected as traditional relationships are gradually eroded by pressure for access to creative financing structures, capable and efficient execution, and performance orientation. Over time, firms and national financial systems capable of offering integrated financial services of various types and with substantial execution and trading capabilities will emerge among the market leaders. Countries should certainly make it a primary goal to evolve towards a financial system that optimizes static efficiency, dynamic efficiency and stability via vigorous competition across and between channels of financial intermediation and the firms operating in those channels. They should also provide national treatment of foreign-based financial institutions, which often are the source of intense competition and financial innovations transferred from abroad. Countries should work to minimize functional and geographic barriers to activities in all types of financial and allied non-financial businesses, including elimination of barriers between banking and insurance. And the regulatory environment should be as competitive as possible-within

Conclusions

115

the bounds of reasonable prudence-with the major financial centres abroad in order to retain as much domestic financial value-added as possible and maximize the prospects of providing them for others as well.

Notes 1. For a full discussion of this issue, see Ingo Walter, The Battle of the Systems: Control of Enterprises and the Global Economy, Kieler Vortrage, Institut fi.ir Weltwirtschaft an der Univeritat Kiel, Neue Folge, No. 122 (Ti.ibingen: J.C.B. Mohr/Paul Siebeck, 1993). 2. Adapted from Mayer (1992) to include the possibility of industrial crossholding systems, such as exist in Japan. 3. For greater detail, see Saunders and Walter (1993). 4. For an elaboration, see Ingo Walter, "The Battle of the Systems", op. cit. supra. 5. It is interesting to note that statements by Deutsche Bank in 1993 questioned the rationale and usefulness of large bank shareholdings in industrial companies, and mooted the eventual disposal of some of the Bank's holdings, including shares in DaimlerBenz. As reported in Financial Times, 18 March 1993. 6. Masahiro Hoka, "Present Situation and Prospects for the Financial Market of Singapore," unpublished working paper, ISEAS, Singapore, March 1993. 7. Chan Sue Meng, "More Avenues to Invest Your CPF Savings from October", Straits Times, 5 August 1993. 8. Monetary Authority of Singapore, The Financial Structure of Singapore (Singapore: MAS, 1989). 9. Data source was the Bank for International Settlements (1993). 10. All data provided by the Monetary Authority of Singapore, March 1993. 11. Stock Exchange of Singapore Ltd. 12. Singapore International Monetary Exchange Limited, Annual Report (1992). 13. Futures Industry, April 1993. 14. During the first eight months of 1993, SIMEX volume totalled almost 10 million contracts, up by about 30 per cent over the same period in 1992.

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The Author INGO WALTER is the Charles Simon Professor of Applied Financial Economics at the Stern School of Business, New York University. He also serves as Director of the New York University Salomon Center, an independent academic research institute founded in 1972 to focus on financial institutions, instruments and markets. He also holds a joint appointment as Swiss Bank Corporation Professor of International Management, INSEAD, Fontainebleau, France, which dates from 1985. He has served as a consultant to various government agencies, international institutions, banks and corporations, and has held a number of board memberships. Dr. Walter's principal areas of academic and consulting activities include international trade policy, international banking, environmental economics, and economics of multinational corporate operations. He has published papers in various professional journals in these fields and is the author or editor of 21 books, the most recent of which is Universal Banking in the United States, published by Oxford University Press and coauthored with Prof. Anthony Saunders. At present, his interests focus on competitive structure, conduct, and performance in the international banking and financial services industry, as well as international trade and investment issues.