Fwd: Stuart Gulliver's speech to BritCham in HK, on 8/11

 

Managing risk in an age of uncertainty

Stuart T Gulliver
Group Chief Executive
HSBC Holdings plc

Tuesday, 8 November 2011
The British Chamber of Commerce in Hong Kong

Thank you Paul for that very kind introduction, and thank you to the British Chamber of Commerce for the opportunity to address this luncheon.

The two best pieces of advice I've been given about public speaking are to talk about what you know and to keep it short. The most important thing I do as chief executive of HSBC is manage risk. Given the extraordinary times we live in I thought risk was also a topical subject.

Let me begin with a simple and somewhat frightening observation. For 10 of the last 15 years at least one major region of the world has been in crisis. The Asian financial crisis of 1997-1999, the dot-com crash of 2000-2002 and the ongoing US and European crisis that began in 2007 have made uncertainty the only certainty.

The current crisis, once known as the subprime crisis or credit crunch, has evolved into a broad economic crisis in parts of the West -- and it's not over. This is part II of the same crisis -- we just had a short intermission. I will come back to HSBC's view of the current crisis and the economic outlook for Asia and the world. I'm happy to take questions later. But please bear in mind we release our third quarter interim management statement tomorrow and I am rather limited in what I can say today about HSBC itself.

But back to risk. If economic and market dislocation is now routine, what has changed?

The world is more connected and there are more ways for stresses and strains to travel from one market or economy to another. It's also true that markets and economies operate at much higher speeds than they used to.

This greater connectivity and higher speed join together in a particularly dangerous way during periods of market volatility. The widespread access to newswires and business television has made it easier to transmit fear instantly. An investor gets in a lift in London, watches Bloomberg TV reporting a sell-off in Korea, gets off the lift, walks to his desk and sells Hong Kong.

This instant emotional response may be irrational but is very real. And I'm not sure why but television seems to intensify the emotional impact of news. The problem is this instant response creates reflexivity through portfolio redemptions and margin calls, allowing emotion to overwhelm facts. In my example the real economy, trade and capital flows for Korea and Hong Kong may have low correlation. Emotion creates a correlation reinforced by the feedback loop of redemptions and margin calls.

I could go on but I think the point is made. Speed has increased and economies are more connected. In many important ways this is a good thing. In this region hundreds of millions of people have been lifted out of poverty in a very short span of time because of rapid economic development.

But there is a downside to increased speed and connectivity -- more crashes. Or to put another way, black swans fly faster and arrive more often than in the past. I think it's highly unrealistic to believe firms or economies can manage risk with such precision that crashes never happen. This makes risk management even more important for individuals, firms and economies.

If the world has changed do we need new risk management tools? I don't think so. We need to apply common sense risk management with more determination. A better appreciation of history would also be helpful.

In their masterful study of eight centuries of financial panic and crisis, 'This Time Is Different', Carmen Reinhart and Kenneth Rogoff show that before a crisis bankers, borrowers, investors and government leaders explain we are smarter than before and we have learned from past mistakes. Society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on sound fundamentals, structural reforms, technological innovation, and good policy. The great lesson for risk management: If it looks to good to be true – it probably is too good to be true.

The basic tools of risk management are well-known. The trick is to use them. Step one is to categorise a risk as short-term, medium-term or long-term risk. Step two is to ask if you have enough or the right information? Step three is to decide how to mitigate the risk.

Volatility and liquidity are classic short-term risks. Can a small export firm survive if its home currency rises sharply in value? Can a big firm survive if it can't roll over commercial paper? For a bank, common sense risk management means having more deposits than loans. Managing short-term risks is mostly about building appropriate safety nets.

A typical medium term risk is an external factor that changes a product market over time. It might be a change in demand for a product because consumer preferences are evolving. It might be the rise of a new class of competitors. A good example of medium-term risk is regulatory change, including the risk of unintended consequences. Managing medium-term risk is mostly about having the right information and the judgement to use it.

Managing long-term risk is mostly about making wise investment decisions. Let me offer an example of a long-term risk in this region. Education is incredibly important in fast-growing economies. A lack of educational infrastructure is just as damaging to an economy as a lack of roads or power. I think many governments in Asia recognised the risk of skills shortages 10 or 20 years ago and did invest in education, but perhaps should have invested even more. This is also an issue in Brazil.

I've oversimplified to make a point. I've made risk management sound easy, which of course it isn't. But it isn't impossible. Let's look at an example.

Regulating the financial services industry is a live experiment in how to manage risk. The challenge for regulators is how to create an effective international financial regulatory system that reduces risk and volatility but does not embed risk aversion.

It is no easy task. The situation is complex and the solutions are contentious.
But there are some key steps that policymakers, regulators, and the financial services industry itself should follow.

The first is to focus on making the right judgements about the underlying causes of the current crisis. This means making some very difficult and unpopular choices.

Second, we have to focus on rebuilding the regulatory framework so that it tackles the multiple causes of the financial crisis. These include poor management, governance, supervision -- and excessive reliance on mathematical modelling.
Third, we have to create a regulatory framework that is stable and transparent because one of the biggest risks we face is that the current regulatory uncertainty leads to a loss of confidence, embedding risk aversion and leading to the withdrawal of capital.

Fourth, we have to build a system that can be applied across all countries – from New York, to Sao Paulo, to London, to Shanghai – even though they exist in very different financial systems and are at different stages in their economic development.

And the final and perhaps most difficult step is to ensure that if things go wrong again the international regulatory system can deal effectively with cross-border issues and limit contagion.

Making all of this that much harder is anger and the desire for punishment. Politicians are under pressure from the public to find somebody to blame and punish them. I understand the anger. The 'occupy' protests are a visible manifestation of this anger.

But I also think there is more than enough blame to go around.

Let me offer an example. The UK -- and in hindsight this does seem unbelievably dumb -- had 110% mortgages. The banks that offered such mortgages -- HSBC did not -- certainly deserve blame. But so do the regulators who allowed such products and the consumers who used them. Again, in the UK, there are consumers with GBP 40 thousand of credit card debt on annual salaries of GBP 30 thousand. Are the banks solely to blame or should an individual have some responsibility for their financial well being?

We need to acknowledge the anger but not lose sight of the broader issue: Regulators need to balance the goal of reducing risk by increasing capital requirements with the need to do so in a way that is affordable for society. It is hard to increase capital and lending at the same time. It's not clear to me that if debt is one of the problems, more lending is the right solution. If regulators require very high levels of capital the cost of credit will increase. In a way this socialises the cost of the banking industry on a PAYE basis ex ante as a frictional cost to the economy, rather than via a taxpayer bail out ex post. It is unproven which is cheaper.

As we move to implementation of new regulations we will need to ensure action is coordinated across the world. And of course the regulatory system should reflect the shift in the world's economic centre of gravity.

Asian leaders and regulators are increasingly making their voices heard on the world stage – and the rest of the world is increasingly keen to listen.

While the current turbulence and uncertainty in the West presents risks to Asia, this region's fundamentals remain sound.

Asia recovered much more quickly than the rest of the world in 2008 and the region's financial systems proved their resilience.

The IMF's most recent World Economic Outlook called the region's track record during the crisis "enviable".

And there are a number of reasons why Asia is in a strong position to manage the effects of any new slowdown in the West. There is strong liquidity in the financial system. Moreover, the region is less dependent on exports to western markets than in the recent past.

The export to GDP ratio in Asia has fallen in almost every country since 2008. In China the contribution of net exports to GDP growth has fallen to zero. Even if the global economy falls into a recession again, reductions in net exports would at most cut China's GDP growth by 1-2 per cent.

Intra-Asia trade has become increasingly important, for example, Korea now exports 20% more to China than it does to the US and EU combined.

Hong Kong is more exposed given its unique dependence on trade and its role as a hub for exports in the region – but there is every reason to believe it will remain resilient.

At the same time, consumer demand is holding up well across the region and, in particular, a range of indicators from China reinforces our belief that it will see a soft landing. Policy tightening appears to be working, and we are already seeing inflationary pressures ease. So we are forecasting growth in China of around 8-9% this year and next year.

This combination of a strong China, robust domestic demand and retail spending means that despite the headwinds elsewhere, the outlook for Asia is positive.

There are, however, some short-term risks to be managed. The strong increases in credit availability in Asia that has supported demand growth cannot continue indefinitely. The credit-to-GDP ratio across the region has risen significantly since 2009. Any reduction in credit availability is likely to be gradual – but it remains a risk policy makers will need to manage. And we need to be careful to monitor the risk of a sharp withdrawal of credit by European banks as a result of events at home.

There is because the risk of a repeat of 2008 with uncertainty and loss of confidence in the West leading to a change in risk appetite and withdrawal of capital from the region. However, many Asian economies still save more than they invest and are not overly dependent on foreign capital.

In Asia, there are long-term risks that require attention. In addition to the education issue I raised earlier, there is a real need to improve access to financial services. A billion people in emerging markets currently have a mobile phone but no bank account and this reduces their economic opportunities.

Asia's economic and social development will also require deeper, more liquid capital markets: more sophisticated capital markets to ensure more efficient allocation of capital; and deeper capital markets to contribute to economic stability and resilience, and to help manage the risks from elsewhere in the world.

I began by noting that at least one region of the world has been in financial crisis for 10 of the last 15 years. It's worth adding that even the current crisis isn't affecting all regions of the world in the same way. It is a sign of Asia's economic maturity that this region does not move in lockstep with the US or Europe.

Asia's resilience also testifies to the success of the region's conservative and gradualist approach to financial regulation. China's step-by-step approach to the internationalisation of the RMB is a fine example of common sense risk management.

Which brings me back to my main point. There is no doubt the world economy has become more accident prone because of an increase in speed and greater connectivity. We don't need new risk management tools. We need to make better use of the ones we have, including old-fashioned common sense.

Thank you.