Sukhdave Singh: Financial governance and economic growth
Keynote address by Dr Sukhdave Singh, Deputy Governor of the Central Bank of Malaysia
(Bank Negara Malaysia), at the Malaysian Economic Convention "Financial Governance and
Economic Growth", Kuala Lumpur, 28 September 2015.
* * *
It is indeed an honour to be speaking to such a distinguished audience. It is also a great
pleasure for me to be here this morning and join my colleagues in the Economics fraternity at
this 2015 Malaysian Economic Convention.
To begin, let me share with you a story.
Twenty years ago, on 28 January 1986, the NASA space shuttle Challenger was launched.
Seventy-three seconds into its flight, spectators were horrified as the space shuttle broke
apart in a fiery display and disintegrated over the Atlantic Ocean. Seven astronauts died. The
catastrophe was traced to the failure of a single O-ring - a simple seal at a joint on one of the
rocket boosters. The O-ring failed due to the unusually cold temperatures on the morning of
the launch. Relative to the highly sophisticated technologies involved in building and
launching the shuttle, the O-ring was considered established technology, one with a patent
history of 90 years by the time the Challenger was launched. It was as ironic as it was
instructive that such a complex machine, incorporating the most advanced aerospace
technology of its time, failed and combusted due to a component as trivial and basic as an
O-ring.
Six years later, Michael Kremer, an economist at Harvard University, formulated the O-ring
theory of economic development1. According to him, if strategic complementarity is
sufficiently strong within a system, O-ring effects can create low-production traps. Financial
Times columnist Tim Hartford relates Kremer's theory to the concept of weak links2. When
systems have a strong element of interdependence, weak links begin to have a more
multiplicative effect, rather than an additive effect, on the overall outcomes of the system. A
musical band is only as good as its least experienced player. A dance troupe is only as
synchronised as its worst dancer.
Today's economies and financial systems have undoubtedly become more intricately
interlinked across agents, markets and nations. This progression brings benefits as it unlocks
new synergies and uncovers diverse sources of growth. However, the increased
interdependence also increases the potential for O-ring type effects. Any single component
within this complex web of economic and financial relationships can become the weak link of
the system, with highly detrimental effects on the system's stability and on economic growth.
The financial crisis of 2008-2009 in the advanced economies was a good illustration of an
O-ring weak link, whereby a seemingly small segment of the US financial system - the
subprime mortgage market - triggered an economic crisis that reverberated around the world
and the effects of which are still being felt today. In many ways, the build-up of vulnerabilities
that led to the crisis arose from a series of bad financial decisions made by borrowers,
bankers, investors and regulators. This brings forth the importance of sound financial
governance as a fundamental element of robust economies and financial systems, one that
ensures that the possibility of the existence of weak links within the system is minimised.
Today, I would like to discuss three inter-related issues relevant to the theme of this
conference. First and briefly, the issue of global financial governance. Then I will focus at
greater length on the relationship between financial governance and economic growth at the
national level. The third and final part of my remarks will cover the governance of finance.
Global financial governance: a lack of urgency
Let me start with global financial governance. I will be brief on this as much of the discussion
has been had elsewhere at various other platforms. Since the demise of the Bretton Woods
system in the 1970s, while the global monetary and financial system has become more
integrated and sophisticated, global financial governance has changed little. The financial
crisis in the advanced economies and the years since have clearly delineated the fault lines
in the global system and accentuated the dire lack of effective global financial governance.
One would think that there would be a greater sense of urgency in collaborating to ensure
that weak links in the system do not have wide-spread contagion. Unfortunately, there is no
such sense of urgency. At its core, the global system remains uneven, unanchored and
unorganised. Let me elaborate.
First, the foundations of the international financial architecture are uneven. As everyone is
aware, there is an over reliance on the US dollar as the reserve currency and by extension,
an over-concentration of risk with the US economy and financial system. The burden of
adjustment is asymmetrical across countries - between deficit and surplus countries,
between debtors and creditors and between governments and the private sector. Despite the
higher contribution of emerging economies to world growth, global policy priorities, decision
making and standard setting remain largely the domain of the advanced economies.
Second, the system is unanchored and crisis prone. With no guideposts, automatic
corrective mechanisms or coordination to facilitate adjustment, the system is prone to
excesses and is perpetually facing disequilibrium conditions, resulting in persistent global
imbalances in terms of both the current and capital accounts, and the unsustainable build-up
of debt. With no means to correct itself, adjustments often occur through costly upheavals in
the form of balance of payments or financial crises.
Third, the system is unorganised with inadequate global response mechanisms. There is
neither an effective platform nor an established framework for policy coordination or for crisis
containment, management and resolution. There is also no true global lender of last resort as
the IMF itself has only limited resources.
This has led to the rise of governance innovations amongst many economies, including
Malaysia and its neighbours. Since the Asian Financial Crisis of 1997, various initiatives have
fostered stronger regional cooperation, including information sharing and alternative liquidity
support arrangements that are bilateral or regional in scope. While these efforts have
reinforced the region's defences against external shocks, they have not reduced the
vulnerability of individual economies to external shocks. Were the fault lines in the global
monetary and financial system to widen, there is no guarantee that emerging economies like
ours will not be dragged into those crevices. Given the lack of global initiatives to close those
fault lines, what economies like Malaysia must do is to ensure that our house is strong. We
must build-up our defences and have the resilience to withstand the volatility and headwinds
created by the global economic and financial environment.
One important source of that resilience is having sound financial governance at all levels of
our society: the government, the corporate sector and the household sector.
Financial governance: foundation of sustainable economic growth
Financial governance sets the stage for sound financial decision-making. Broadly defined,
strong financial governance is a sum of many parts including strong institutions, efficient
processes, and effective rules, regulations and norms. It affects the way financial decisions
are made, including decisions relating to savings and spending, borrowing and lending,
investment and profit distribution, and it is relevant to all economic agents, be they
households, businesses or governments.
Soundness of financial governance is a critical prerequisite for the sustainable growth of any
economy. Having said that, we also have to recognise that the process of economic growth
itself is an outcome of a system that is highly complex and adaptive, and that a country's
economy, polity and society - and the institutions that underpin each of these - are
embedded within a complex network of interdependencies. Therefore, there cannot be a
one-size-fits-all prescription of what constitutes good financial governance for all economies.
Nevertheless, I do believe that we can recognise the presence or absence of good financial
governance based on broad characteristics. In this regard, three key inter-related features
are typically present when there is good financial governance.
Firstly, effective financial governance ensures that financial decisions take into account all
externalities arising from the decisions. Financial decisions often have consequences that
are not fully borne by the decision maker. Financial decisions that may appear rational at the
individual level, may in fact be collectively unsustainable. For instance, corrupt practices may
be optimal for the individual perspective, but they are clearly detrimental to the welfare of
society and the economy. In order to avoid the misallocation of resources, these externalities
have to be internalised either by aligning the incentives of the decision maker; introducing a
more representative decision-making process; putting in place the appropriate institutional
arrangements; having effectively enforced laws, rules and regulations; or occasionally, by
societal norms.
Secondly, sound financial governance encourages discipline in adhering to the budget
constraint. All economic agents are bound by inter-temporal budget constraints, and
adherence to it when making financial decisions is key to sustainability. This is particular
relevant when the repercussions of financial decisions fall on parties who are not
represented - for example, decisions that shift a large debt burden onto future generations.
Thirdly, strong financial governance has robust external checks and balances. To ensure
sound decision making, especially when externalities are involved, decision makers, and the
decision making process, must be subjected to scrutiny by external parties. In this regard,
accountability, transparency, and the empowerment of the external party to take
consequential action are key to effective financial governance.
All these principles apply fully to the management of public finances. Sound public
financial governance is the legitimate use of authority in the management of a country's
financial resources with integrity to promote sustainable development.
At the heart of it all, sound governance practices in the Government can be traced back to
the concept articulated by French Enlightenment political philosopher (Baron de)
Montesquieu in the 18th century. The separation of power between the legislative, executive
and judicial arms of the government safeguards against authority being excessively
centralised in any particular party. It is the effective separation of power that provides the
checks and balances that ensure that there is strong financial governance at all levels of
government. It is the effective separation of power that ensures that the decision maker not
only considers his or her self-interest but also that of the society at large. It is the effective
separation of power that ensures that the risk of abuse or misuse of public funds is
minimized. Therefore, if you want to know the state of public financial governance in a
country, the first question to ask is whether there is effective separation of power.
To a great extent, the current state of public finances reflects the past track record of
financial governance in the public sector. If the state of fiscal health in the crisis-affected
economies had been in a better condition, monetary policy would not have had to do so
much heavy lifting, QE may not have seen the light of day, and we may now be having better
economic growth. When there is an imbalance in macroeconomic policies, or when such
policies are used as substitutes for structural reforms, the long-term outcomes will always be
sub-optimal, not least because of the distortions and imbalances that are created.
It is certainly the case that the recent crisis has been a key factor behind the increase in
government indebtedness. In the aftermath of the crisis, governments in the crisis affected
economies had to use public funds to rescue troubled banks. For example, Ireland had a
government debt to GDP ratio of just 24% in 2007, but due to its banking crisis and its impact
on the Irish economy, that number jumped to 111% by 20113. In fact, even for countries that
were not at the centre of the financial crisis, fiscal spending to stimulate domestic demand
was increased to offset the negative real sector shock created by the crisis. The low growth
environment also reduced the tax revenues of governments, further eroding public finances.
So, the crisis certainly played a role in the worsening of public finances.
But that is not the complete story. In many countries, public finances were already stretched
even before the crisis. This surely says something about the state of financial governance in
the public sector of these economies. In the advanced economies, ageing populations and
over-generous health and pension benefits were a major source of strained fiscal positions.
Although the threat of demographics to fiscal sustainability is at this juncture most imminent
for countries such as Japan, Spain, Italy and Greece, where the old age populations are
rising most sharply amid already high levels of debt, it is only a matter of time before many
emerging market economies will also face similar issues. That includes countries in ASEAN.
It is therefore imperative that the public financial governance adequately embed such
longerterm considerations into financial decisions being made today.
In many emerging market economies that have endowments of resources, the state of
financial governance is also reflected in how governments managed the riches that flow from
these resource endowments, especially in terms of providing for future generations and
saving for bad times. Sadly, there are too many examples of countries that have badly
managed their resource wealth. Not only have they failed to save for the future, even their
use of the resource wealth has contributed minimally to supporting sustainable economic
growth, often because much of that wealth is pillaged by those responsible for its
management.
The practise of good public financial governance is evidenced not just from the pattern of
spending but also from the effectiveness of implementation and the achievement of
outcomes. For example, education and talent development is a key priority in many
countries, emerging as well as developed. Large amounts of public funds are devoted to
education. On the surface, it may look like good financial governance to spend so much
money on such a socially and economically desirable objective. Yet, much of that spending
goes to waste if there are no accompanying measures to bring about other complementary
changes such as raising standards and professionalism, addressing incentives, and ensuring
that what is taught meets the needs of the economy. High spending of public funds and the
persistence of mediocrity will go hand-in-hand if no one is likely to be held accountable for
failure to achieve outcomes. Therefore, good financial governance must be measured in the
achievement of specific and measurable outcomes. If the outcomes fall short, then tax-payer
money cannot be considered to have been well spent.
When there is a lack of financial governance in the public sector, it means that government
contracts are awarded based on who you know rather than who can give the best value for
the money. As a result, government projects often become costly, poorly delivered and fail to
provide the incentives for increased proficiency and productivity. Not only that, a pool of
vested interest develops to feed on the lack of financial governance, and any threats to their
privileged livelihood are met with great hostility. It is the privileged position of this vested
interest that makes government reform so difficult. The end result is that the intention to have
an economy that is driven by efficiency and increasing productivity remains unattainable.
There are countries that have gotten it right when it comes to good public financial
governance. For resource rich economies, Norway is one example, where since 1990, the
government has put aside its oil income in a fund that at the end of 2014 was worth almost
US$1 trillion4. The sustainability of the fund has been supported by a fiscal rule that specifies
that over the course of the business cycle, the government can only spend the expected real
return on the fund but it cannot use any of the fund's capital. For another example, this time
of a country that does not have any significant resource endowments, Singapore is
considered to have prudent public financial governance. Again the fiscal rectitude is guided
by legal constraints. For example, the country has adopted a legal constraint to balance the
budget over the government's term in office. It also maintains an internal discipline of
keeping government spending at below 20% of GDP5. By comparison, most developed
countries have government spending at around 40-50% of GDP. So, good public financial
governance is possible, assuming there is the political will to put in place the appropriate
mechanisms.
What about financial governance in the private sector? The financial crisis in the advanced
economies and the years since have shown how unsustainable household finances can
drag down economic growth for many years. Excessive leverage and high household
indebtedness often have negative economic implications. In pondering the issue of financial
governance at the individual and household level, I am reminded of Leo Tolstoy's infamous
quote from Anna Karenina, "All happy families are alike; each unhappy family is unhappy in
its own way." There are indeed numerous causes of unhappiness, but being confronted with
the consequences of bad financial decisions made in the past must surely be a common
cause of much unhappiness among many families.
This issue is especially pertinent in the current environment of prolonged low interest rates.
Sound financial decisions are needed to ensure that households do not live beyond their
means and accumulate excessive debt. This is essential to ensure the sustainable growth in
consumption, rather than having debt-fuelled consumption binges followed by prolonged
slumps. It is these types of considerations that have made Bank Negara Malaysia maintain a
level of interest rates that we believe balances between supporting the economy and
discouraging excessive risk taking. This has been supplemented with other policy tools,
including macroprudential policies, to manage risks within the financial system and economy.
Therefore, it is not only national governments themselves that must practice sound financial
governance, they must also promote it as a key priority within the society and not create
incentives that lead to unsustainable financial behaviour among economic agents.
Turning now to the corporate sector, at the surface, corporate financial governance appears
to have ample checks and balances. Management is accountable to boards and boards are
accountable to shareholders. For publicly listed companies, there is the market discipline of
the share price taking a beating for any perceived shortfalls in financial governance.
Unfortunately, history is replete with incidences of the failure of such checks and balances,
including the repeated failure of markets to impose financial discipline on corporations.
Notable examples of the failure of corporate financial governance include the Carrian Group
in 1983, Enron in 2001, Worldcom in 2002, and the numerous examples from the recent
financial crisis. The narrow fixation on profit maximisation has, in many cases, led to the
misallocation of resources, including the channelling of funds towards unproductive activities
for purposes of rent extraction and speculation. This harms economic growth as productive
segments are under-invested in.
The functioning of markets also needs to be improved. Given the widespread abuse and
attempts at manipulation, I believe that appropriate regulations, and their enforcement, can
help to ensure that markets function as intended, and support the greater good of society,
rather than just the greed and self-interest of the market participants.
There is one final aspect of corporate financial governance I would like to mention, and this
has to do with what I consider to be one of the biggest threats to future economic growth -
environmental sustainability.
The damaging effects of activities such as deforestation, over-fishing and excessive
emissions on the environment, have wide-ranging implications not just on the future quality of
economic activity, but on the quality of life itself. Progress has been made both in terms of
regulations and the increased sensitivity of corporations to their environmental footprint.
However, the progress is relatively small and developing economies are particularly
vulnerable to being made the choice location for the so-called dirty industries. The pursuit of
profit is a powerful motivation for corporate existence and unfortunately, it often leads to
short-sighted behaviour. The ongoing Volkswagen scandal is a clear example of this. Again,
it reinforces the need for sound government regulation in ensuring that financial decisions
taken by corporations are not only good for those corporates but also for society as a whole.
Let me now move on to the last part of my speech, which relates to the governance of
finance. After all, the availability of finance is a key constraint for economic agents and
therefore, a key determinant of economic activity.
Governance of finance: anchoring finance in the real economy
The need to maintain sound financial governance of financial institutions is best
demonstrated through the impact of its absence. The recent crisis is a stark reminder that
weak financial governance of financial institutions can result in unsustainable levels of
leverage, excessive maturity mismatches and underpricing of risk within the financial system,
ultimately leading to widespread wealth destruction and economic dislocation. In the US
alone, conservative estimates have placed the loss from the financial crisis at between
$6 trillion to $14 trillion, or 40 to 90 per cent of the annual economic output6.
In response to the global crisis, more extensive international reforms have been pursued to
strengthen the financial buffers of financial institutions through, among others, stricter capital
and liquidity requirements. These reforms have helped to strengthen the balance sheets of
financial institutions and sustained their ability to support orderly financial intermediation.
While I acknowledge the importance of these reforms, there is an even more important issue
related to the overall "governance of finance". The financial crisis contains many lessons on
how governance of finance failed as well as the consequences of such failure. The
governance of finance relates to the behaviour of financial institutions and their determinants
from the perspective of organisational arrangements, incentive structures and ethics, as well
as the regulatory and market environment. When these factors are correctly aligned, the
financial system plays its role in supporting sustainable economic growth; when they are not,
the financial system creates risks that can potentially undermine economic growth. Central to
the robust governance framework of financial institutions are strong institutional
arrangements that provide effective checks and balances to facilitate sound decision-making.
At the broadest level, this entails well-defined responsibilities and accountabilities,
underpinned by a clear separation between board oversight and management. While this
may appear to be a rudimentary feature of any governance arrangement, it may be
challenging in organisations that are large and have complex or opaque reporting lines,
resulting in boards and senior management that are too far removed from the issues on the
ground. "Too big to manage" is a real concern. In their reflection of banking practices leading
up to the crisis, the United Kingdom's Parliamentary Commission on Banking Standards
found that an "unclear, complex and confusing allocation of responsibilities" among senior
management had posed challenges in identifying individuals who were responsible for poor
decisions and more importantly, in holding them to account7. This is an important lesson to
keep in mind for Asia, as our financial institutions continue to significantly expand their
operations across sectors and geographical boundaries.
In ensuring the effectiveness of governance structures, none is more important than having
competent and committed individuals at the helm of financial institutions. The members of
the board of directors must have a sound understanding of the business, the risk profile of
the financial institution, and the operating environment. The board must also be ready to
challenge executive management and hold it to account. This demands a combination of
experience, confidence and character - elements which were found lacking among financial
institutions in the recent crisis. A Financial Times report in 2008 found that most directors at
several large and troubled institutions had no significant experience in financial services8. An
undue deference to management by directors was also prevalent in banks such as Northern
Rock, HBOS and RBS, where the boards did not adequately challenge the management's
pursuit of aggressive, high-risk strategies.
It is for these reasons that Bank Negara Malaysia undertakes rigorous and frequent
supervisory engagements with the boards of financial institutions. Such engagements are
crucial to developing a better understanding of board dynamics and their effectiveness in
their governance role. As a matter of practice, prospective directors of financial institutions in
Malaysia are subjected to close scrutiny through rigorous interviews by the Bank. This
approach was also recently adopted by the UK's Prudential Regulatory Authority9.
Governance arrangements in financial institutions must also be reinforced by a corporate
culture which values and reinforces considerations for risk, ethics and compliance at all
levels of the financial institution. This starts with the right "tone from the top", whereby the
board and senior management shape the core values for the firm. A common theme in the
findings across various inquiries into the crisis is a breakdown in culture, where a disregard
for prudence and ethics was tolerated. In some cases, individuals bearing red flags were not
only ignored, but punished. The Financial Crisis Inquiry Commission launched by the US
government chronicles two such instances10. In Lehman Brothers, the Chief Risk Officer
(CRO) was stripped of her role in risk matters after warning against too much risk in the face
of growing pressure to compete against other investment banks. Similarly, repeated
warnings raised by the business chief underwriter of Citigroup against large purchases of
defective loans did not translate into action; instead, he was downgraded in performance
reviews and subsequently demoted.
Another major component in the governance of finance is how individual incentives are
influenced through compensation. The global financial crisis offers a telling display of how
incentives were misaligned through the widespread adoption of compensation systems that
rewarded short-term performance. In the US, loan officers at Washington Mutual were
rewarded more for originating higher risk loans, while loan processing personnel were
compensated according to the speed and number of loans processed, rather than loan
quality. Meanwhile, AIG Financial Products compensated its employees, including risk
officers, on the basis of revenues brought in rather than profits. At Lloyds, incentive
schemes which pressured sales staff to meet targets or face demotion also encouraged
misselling of payment protection insurance. In all these instances, executives were inclined to
focus on immediate outcomes such as revenues and sales targets in order to deliver visible
results quickly, without much regard for the risks assumed. Major efforts have since been
undertaken internationally to address these issues. The essence of these reforms is
twopronged: the first is a greater emphasis on the governance of the compensation framework
by the board and senior management; the second is a greater alignment of compensation
practices with prudent risk-taking. As risks undertaken today may materialise much later in
the future, the latter entails deferring portions of compensation and subjecting them to
adjustments, such as bonus-malus and clawbacks.
Finally, a strengthened role of market discipline can also shape the governance of finance for
the better by reducing information asymmetries between the market and financial institutions.
Again, regulations can play a part by enhancing the scope and quality of mandatory
disclosures, such as in respect of key information relating to risk exposures, risk
management policies and capital ratios. A relevant emerging trend among investors and
consumers has been an increasing focus on more sustainable approaches to finance,
including those which consider environmental, social and governance concerns. For
example, large institutional investors, including sovereign wealth funds, have started to
channel more funds to firms with sustainability commitments. Admittedly, the progress made
on this front has been rather modest thus far, but it does have the potential to enable a wider
range of stakeholders to determine the sustainability of finance and its role in facilitating
sustainable economic growth.
Conclusion
I have not actually finished my story on the Challenger shuttle disaster at the beginning of my
speech. After the harrowing accident, President Reagan formed the Rogers Commission to
investigate the incident, and it was found that the accident could have been avoided entirely.
The special commission reported that NASA's organisational culture and decision-making
processes were key contributing factors to the catastrophic event. NASA managers had been
aware of the potentially fatal flaw in the O-rings since 1977, but did not respond
appropriately. And on that fateful morning, warnings from engineers about the risks of
launching in the low temperatures were met with contempt, and the superiors were not
adequately notified of these technical concerns.
Therein lies the importance of governance structures and how decisions are made.
Governance influences decisions, and decisions shape outcomes. It is no different for
financial governance. Be it financial decisions at the international or national level, public or
private, corporates or financial institutions, households or individuals, sound financial
governance is the bedrock of stable and robust economies. The fact that a lack of good
financial governance increases the likelihood of O-ring-like accidents, with potentially
devastating effects on the economy, should make sound financial governance an economic
and political priority.