Tsinghua University School of Economics and Management

1
Tsinghua University School of Economics and
Management

• Lecture 2008/2
• A Historical Introduction to Governance
• and Leadership in Regulatory Environment
• Andrew Sheng
• Adjunct Professor
• 15 March 2008

2
Preliminary Thoughts

• ??????????,??????,?????,??????,????????.
• ???????,???,???,???,????
• How different is this from an Adaptive,
  Learning, Evolving Socialist Economy?
• Chinese Development by Opening Up, Learning,
  Adapting, Competing, Cooperating is truly
  Complexity Economics!
• Regulation has a role in Complexity Economics
  because Regulator is Reflexive and has major role
  in shaping social behaviour in accordance with
  policy objectives!!

3
Content

• Historical Introduction to Governance
• I. Definition of Finance, Regulation and
  Governance
• II. Methodology From Neo-Classical Economics to
  New Institutional Economics
• III. Putting Regulation and Governance in a
  Historical and Institutional Context
• Leadership, Decision-making and Team-work
• Routine work is where all decisions are already
  made in the work-process
• If you work routinely, you do not learn how to
  work and respond to environmental change
• In this session, we draw on Military History and
  Modern Management to learn how to think
  strategically and act tactically
• All work is about Management!

4
Malcolm Sparrow (?????????) ????

• ???????,???,?????
• ????,???? - ??.
• ?????????,???? ???
• ???????,???????????? ???,??????????????,?? ????
  ????????????????? ??????
• ?????????,????,????

5
I. Definition of Finance, Regulation and
Governance

• Finance is a derivative of the real sector.
• Financial market is a system to delineate, trade
  and protect property rights.
• Institutions include any form of constraint that
  human beings devise to shape human interaction.
  Therefore, an essential part of the functioning
  of institutions is the costliness of ascertaining
  violations and the severity of punishment. North
  (2005) pg 4
• Hence, regulation and finance are the tools of
  governance.

6
An Economy is a Social Institution - it must have
Governance

• Organizations..are groups of individuals bound by
  some common purpose to achieve objectives.
  Modeling organizations is analyzing governance
  structures, skills, and how learning by doing
  will determine the organizations success over
  timeNorth (2005) pg 5
• Institutions affect the performance of the
  economy by their effect on the costs of exchange
  and production. The major role of institutions
  in a society is to reduce uncertainty by
  establishing a stable (but not necessarily
  efficient) structure to human interaction.
• Every social unit has its own Governance
• Family - patrilineal or matrilineal rules
  ?????????
• Clan, Club or Group - social rules ????
• Enterprise - Corporate Constitution ????and
  Governance
• Government - Public Governance, Law and
  Enforcement
• Market - market rules

7
Differences in Approach to Governance

• Anglo-Saxon - Village Community evolved Common
  Law ???. Manorial system prevented
  centralization of power in monarch (Magna Carta)
  by ensuring power of taxation and individual
  property rights are protected via judiciary and
  parliament. Organization Structure at point of
  time
• England-European Continental competition created
  innovation via maritime/commercial power -
  external conquest was driven by merchants that
  generated market resources to reinforce
  technological advance Dutch East India Company,
  British East India Company.
• Japanese late-Tokugawa period ??????had already
  established competing fiefdoms (daimyos) that
  were structured along commercial lines.
  Shogashoshas (industrial groups) led way for
  military-industrial complex.
• Chinas land-based agrarian bureaucratic
  organization structure was inward looking???,
  self-satisfied, rigid and did not use market
  forces to innovate scientifically and
  organizationally to meet Western competition and
  invasion ????.

8
Diversity and Path Dependence of Governance Modes

• Because Society is an Institution, it has an
  Architecture, which can be has different shapes.
• Social Institutions are path-dependent. They are
  formed and shaped by History, Culture, Geography,
  Environment and past experience.
• Man shapes history, but history and mega-trends
  also shape Man and Society.
• Hence, the need to understand Macro-History.

9
II. From Neo-classical Economics ?????? to New
Institutional Economics
10
Western Theory vs. Chinese Pragmatism

• Western Intellectual Tradition is Deductive ?? -
  use basic principles to evolve a theoretical
  framework of the real world.
• Chinese Intellectual Tradition is Inductive ?? -
  use real world experience and history to guide
  behaviour.
• Western thinking is bold and encourages grand
  thinking, but is faulty when the assumptions and
  deductions are wrong.
• Chinese Pragmatism is cautious, but tends to be
  less open, because the thinking is path dependent
  (bound by history and experience), less willing
  to experiment.
• Creativity comes from the integration of two or
  more different intellectual traditions. We must
  use Western (Scientific) tools to analyze Chinese
  history, and we must use Chinese pragmatism
  ???????to evaluate Western theory.

11
Institutional Economics Path Dependency ???? ????

• ??????????,??????,?????,??????,????????.
• Economic change depends largely on adaptive
  efficiency - a societys effectiveness in
  creating institutions that are productive,
  stable, fair, broadly accepted and responsive to
  political and economic feedback. Douglass North
  (2005)
• ???????,???,???,???,????
• ????,????,?????
• The key to understanding modern social
  development is understanding the transition from
  limited to open social access orders, which only
  a handful of societies have managed since WWII,
  Douglass North, Wallis and Weingast, 2006

12
Game Theory and Chinese Thinking

• Social Interaction is all about game theory - how
  two or more persons interact and react to each
  other
• Game Theory involves co-operation (join
  institution) or defection (join another competing
  institution) ??
• ????,?????
• In other words, the most important social
  decision is to join or cooperate I.e. obey
  rules or defect dont comply and join
  opposition.
• How and why and under what conditions, market
  participants join or co-operate has not only
  participant consequences, but also social
  consequences ??
• Tragedy of the Commons ??????- Garrett Harding,
  1968, on social cooperation or social destruction
  and damage of public good ???.

13
Policy is interplay between Personality and
Institution

• Political observers assume that policy is
  formulated by few leaders, ignoring the role of
  institutions. .Susan Shirk
• The way in which beliefs?institutions?organization
  s?policies?outcomes evolves has led to
  unparalleled economic well-being and to endless
  disasters and human misery. North 2005 pg 155
• In a Coasian world the players would always
  choose that policy that maximized aggregate
  well-being with compensation for any losersbut
  the real transaction costs are frequently
  prohibitive reflecting deep-seated beliefs and
  prejudices that translate into such prohibitive
  transaction costs. 156
• Altering the performance of an economy for the
  better takes time - a lot longer than the time
  horizon of the politician who must approve such
  changes. In the short run the reform may
  necessitate alterations that leave some of the
  players worse off, and if they have access to the
  political process they may very well derail the
  reform. 157

14
Innovation, Imitation and Knowledge Organizations
in Economic Development

• Schumpeter ???argues the key role of
  Entrepreneur in Creative Destruction. ?????
• However, value creation or superior performance
  (company, economy, nation) depends on innovation
  and organization - specifically how institutions
  organize knowledge and apply them for commercial,
  strategic or national advantage (Joel Mokyr, 2000
  and 2002), e.g. venture capital, private equity,
  technology parks.
• The policies required to initiate a transition
  from a low-income equilibrium to a state of rapid
  growth may be qualitatively different from those
  required to re-ignite growth for a middle-income
  country Rodrik (2003)
• It is not always necessary to create replicas of
  Western-style state legal institutions from
  scratch it may be possible to work with such
  alternative institutions as are available, and
  build on them. Avinash Dixit (2004)

15
Key Elements of Social Change

• Stock ??- Organization Structure at point of time
• Flow ?? - Process of Change, shaped by internal
  and external factors.
• Internal Factors - Process change, organizational
  re-structuring, power struggle, corruption,
  incompetence and policy mistakes.
• External Factors - Rebellion, External Invasion,
  Natural Disasters, Competition, Changes in Market
• To be sustainable, organization structure must be
  flexible and maneuverable against both internal
  and external forces.

16
Social Change is like a path-dependent Decision
Tree - society can go down different paths
depending on historical decisions
Fig. The Expansion Process of an Epidemic
17
???????????

• ???? Incentive Structure ? ?????????,?????.???,?,
  ??? ???
• ???? Principal-Agent Problem - ????
• ????? Information Asymmetry - ?????????,??????,
  ????,?????,?????????-??/??
• ??? - ???? ?????,???
• ???? - ???,???
• ???????-??????

18
III. Chinese Macro-history and Governance????
????????????
19
Ray Huang China - A Macro-History(????????)

• As the world enters the modern era, most
  countries under internal and external pressure
  need to reconstruct themselves by substituting
  the mode of governance ????rooted in agrarian
  experience with a new set of rules based on
  commerce. Since commercial distribution focuses
  on exchange, all economic and social components
  within the society must accordingly be made
  interchangeable before the law.
• This is easier said than done. The renewal
  process could affect the top and bottom layers,
  and inevitably it is necessary to recondition the
  institutional links between them. Comprehensive
  destruction is often the order and it may take
  decades to bring the work to completion (Preface
  to the Turn of the Century Edition, xiii)

20
Geography shapes Governance

• Three Geopolitical Threats - Three Kingdoms
• Loess-based Central Plains, watered by Yellow
  River, that carries 46 silt, vs.. 12 for
  Amazon. Hence, continual flooding that required
  centralized authority needed upriver to build
  dikes and irrigation to prevent flooding
• Monsoon climate, with rain concentrated in 3
  months, from Han to end of dynasty of 2117 years,
  1,621 recorded floods and 1,392 droughts. Hence,
  water management and flood control also required
  central authority
• Foreign Invasion - Long border with Huns ??and
  Tibetan ??nomads required national defense
  capability, e.g. Great Wall, that also required
  central authority
• Wei ?, the Northern Central Plain Shu ?, the
  landlocked rice bowl, and Wu ?, the Coastal water
  kingdom.

21
Stylized Chinese Imperial Organization Chart

• Qin had 36 commanderies - subdivided into towns
  and villages
• Han divided into half commanderies and half
  hereditary lordships, governed by royal relatives

22
Stylized Four Level Imperial Organization
ChartFrom Center down to Village

• Each Level Structure basically the same
• Prone to split if too much power delegated from
  center to lower levels
• Historical swing from centralization to
  decentralization caused by homogenous unitary
  top-down structure

23
The Agrarian Bureaucratic System was fiscally and
financially unmanageable.

• By Qin Dynasty (221- BC), China was already
  divided into 36 commanderies, each with civil
  governor, military commander, and a
  censor-in-chief (35).
• China is the only nation in the world that has on
  record permitted the central government to tax
  the individual peasant household from the
  pre-Christian era to the twentieth century.
• Taxation was on land-tax, plus services in kind
  for communal labor or military conscription,
  calculated at one-thirtieth of land yield (3.3).
• By Han Dynasty, the Chinese emperor had to rule
  over 60 million people with 130,000 bureaucrats
  (2.1).
• There was a natural tendency for the wealthier
  and more powerful to displace the poorer and
  weaker. The government, unable to implement any
  plan of progressive taxation, would first face
  the loss of revenue, and then the effort to
  provide relief to the poor would also suffer.
• China achieved imperial unification ????well
  ahead of its time local customs did not have an
  opportunity to develop and mature. The pattern
  of small holdings put any meaningful legal
  service beyond the reach of the villagers. Thus
  rarely were cases of indebtedness, mortgage,
  foreclosure, and dispossession carried out under
  the orderly supervision of the law. As a rule,
  it was the local ruffians who took matters into
  their own hands, conveniently under the direction
  of the rural wealthy. (63)

24
Mathematically Manageability - the evolution of
Financial and Fiscal Capability

• A system of monetary management distinguished by
  the following three conditions-
• Wide extension of credit
• Impersonal management and
• Pooling of service facilities
• Monetary Management must extend to embrace the
  entire national economy including the agrarian
  sector no less than industry and commerce. A
  competent judiciary system is necessary to back
  it up, so that the interchangeability of value
  can be clarified and enforced and the accumulated
  wealth can be piled steadily higher.
• Implementing these conditions, a capitalist
  country permits private enterprise to play a
  dominant role private capital therefore
  exercises a disproportionately wider influence
  over public life. With this price paid, the
  public frees itself from unnecessary governmental
  regulation and gives free rein to economic forces
  so that competition can achieve the greatest
  efficiency. Socialism modifies the system with
  strong public participation and control (266).

25
What is Missing? Property Rights Infrastructure

• Just like China has succeeded in strengthening
  growth through physical infrastructure, a
  property rights infrastructure is the missing
  part in Ray Huangs middle superstructure
• Accurate and Accessible Information -
  Transparency
• Reliable Property Registry (not easily forged)
• Independent Judiciary to adjudicate property
  disputes
• Independent Regulators to enforce laws
• Market oriented financial intermediaries and
  supporting institutions to facilitate transfer of
  (mathematically manageable) property rights
• Property Rights Infrastructure helps to define,
  delineate, transfer and protect property rights

26
Conclusion and Implication

• Chinese history has great lessons for governance
  in economic development.
• Closed systems become rigid and
  obsolete/non-competitive. Very often, old systems
  collapse (Ming) and need new outside leaders
  (Qing) to break deadlock.
• Governance has both cost and benefit. The cost
  is financed through taxation. If benefits of
  governance are less than costs, then society
  fragments or breaks down.
• Governance through moral values ????and penal
  code ??alone is insufficient to prevent
  corruption and administrative abuses????.
• We need to scientifically analyze institutional
  behaviors and examine modern practices to
  consider how best to regulate and govern
  effectively to achieve social goals of growth,
  prosperity, justice and harmony.

27
????

• ??????,??????, ?????, ?????, ??????,???????
• --- ???? ????
• It is standards and regulation that enable man to
  be free from faults it is elaborate preparations
  that free him from difficulties it is worry
  about the detail that ensures prudence it is
  management of great affairs that cultivates
  wisdom it is courage of enforcement that rids
  crime it is caring for the small people that
  wins public support.
• ??????,???????,????????????,????? --- ?????
• A lawless country leads to chaos, whereas an
  inflexible law leads to irrational decisions.
  Laws must change with the times.

28
Leadership is at all levelsof decision-making

• Malcolm Sparrow
• Pick Important Problems, Fix Them and Tell
  Everyone!
• Chinese Saying
• Seek Truth from Facts ????
• Training is about feeding you facts and
  information
• Education is to make you think for yourself
• In life, it is not always the answer that is
  important, but asking the right question.
• What is the right question?

29
Skills of decision-making are learnt, not
inherited

• No one likes to make decisions, but we have to!
• No decision is still a decision!
• Sometimes not a bad thing to wait, but it must be
  a conscious decision to wait, not wait because
  you do not want to make a decision i.e.
  procrastination\
• Most unhelpful decision is Noted - ???? What
  does the boss mean?
• We all make mistakes! ????
• Better that we learn from our mistakes, than
  continuing making them.

30
Communication is best when it covers both Context
and Detail

• Big Picture if you only talk about Big Issues,
  large policies, no one understands you
• Too much detail if you only understand the
  detail, you cannot see the wood from the trees
• The best way to communicate is when you present
  both a coherent story, within the context of what
  your audience appreciates, with enough detail to
  back up to Reality
• Remember in front of the TV Camera or the
  Minister, you have only five minutes to make your
  case
• Execution is easy when message is simple - no
  room for confusion. ????.

31
Decision-making is a cycle

• Decision cycle is
• Information Gathering ??
• Analysis ??
• Weighing up the options - risks vs. returns
• Focus and Prioritize
• Linear Programming (Constrained decisions)
• Decision ??
• Acting on Decision ??
• Assessing the results ??
• Feedback and Review Decision

32
Learning to Learn - Stiglitz

• The overwhelming variety and complexity of human
  societies requires the localization of knowledge
• Practical know-how is largely tacit knowledge
  that needs to be learned by horizontal methods of
  twinning, apprenticeship, and seconding, and
• Each society, through its knowledge institutions,
  should take the active role ("in the driver's
  seat") in the local learning process.
• One size of "clothing" does not fit all
  societies, a society learns to be a "tailor"
  partly by apprenticeship.
• A society should be its own "tailor" to find the
  best fit.

33
Montgomery of Alamein on Leadership My Doctrine
of Command

• Leadership is the capacity and the will to rally
  men and women to a common purpose, and the
  character which inspires confidence.the good
  leader will first study the problem and will then
  grapple with it
• Malcolm Sparrow Pick Important Problems, Fix
  them and Tell Everyone!
• The art of command lies in understanding that no
  two situations are ever the same each must be
  tackled as a wholly new problem to which there
  will be a wholly new answer.
• Here lies a man who died of exhaustion brought
  about by pre-occupation with detail. He never
  had the time to think because he was always
  reading papers. He saw every tree, but never the
  whole wood.

34
Think Strategically, Act Tactically

• Life is a game of infinite permutations
  combinations
• All real-life situations are like a game, in
  which your decisions affect others, and their
  decisions affect your action or non-action
• Decisions depend on the quality of information,
  what information you have on your own situation
  and resources, and those of others in the game
• You always act under conditions of uncertainty
• Managing is all about learning to make these
  decisions under uncertainty risk
• Therefore we can learn from how military history
  deals with decision-making under uncertainty
• Instead of war, think about competition.

35
Think Laterally - the Past is Not Necessarily
Predictor of Future

• Key Trends
• Lineal - Past is good predictor of Future
• Algebraic - Trend follows a formula, but which
  formula?
• Random - too many different changes
• Chaotic - Impossible to predict, but may have a
  pattern.
• Reflexive - Heisenberg Principle - environment
  affects decision-maker and your decisions affect
  environment.
• Risk can be measured. Uncertainty cannot be
  measured.
• Prepare for all contingencies.

36
Sun-zi Art of War, 403-221 BCStrategic
Calculations

• In any game, assessing who wins or loses depends
  on five factors
• ? Tao the Way Values
• ? Heaven/Climate - Timing
• ? Earth/Terrain Environment and Conditions
• ? Generalship - Command
• ? Law/Discipline/Method
• Incentive Structure
• How do we interpret this in modern terms?

37
Questions to ask in assessing winning side

• Which side has the moral right (Tao or values)?
• Which side has the abler leader?
• Which side has the better timing and terrain
  home or away?
• Which side has superior strength in terms of
  manpower and resources?
• Which side is better trained?
• Which side has clearer rewards and punishment
  clear incentive structure?

38
Know yourself and know the competition...

• He who knows the enemy and himself
• will never be at risk in a hundred battles
• ????
• He who does not know the enemy but knows himself
• will sometimes win and sometimes lose
• He who knows neither the enemy nor himself will
  be at risk in every battle
• Sun-zi.

39
Strategy is the art of distributing and applying
military means to fulfill the ends of
policy.Liddell Hart

• Deterrent strategy The supreme act of war is to
  subdue the enemy without fightingSun-zi
• Offensive strategy If you dont fight, you cant
  win and if you cant win, you lose.Barrie James,
  Business War Games, 1984
• Defensive strategy Defense is the stronger form
  of war.Carl von Clausewitz
• Retreat - when you cant win. ????
• Strategy is only as good as Execution!

40
Reliable, Timely Information is a Market
Fundamental

• Raw data is useless without classification and
  analysis
• Information Classified Data
• Knowledge Analyzed Information
• Wisdom Knowledge with judgment and experience
• Computers can speed up classification and
  analysis
• But you still need people to make the judgments
• Regulators have tons of data which we do not
  analyze!!

41
Intelligence for a Regulator Comes from Many
Sources

• Regulatory Reports (could be wrong)
• Field Inspection Reports (to confirm off-site
  reports)
• Discussions with auditors and management (check
  from the regulatee directly)
• Media reports (no smoke without fire)
• Consumer complaints (indicator of bad management)
• Competitors complaints
• Whistle-blowers or insider complaints
• But all intelligence is useless if Regulators do
  not know how to analyze such information.

42
The Changing Organization

• Traditional Organization rigid top-down
  structure of departments, reporting lines, set
  procedures
• Outcome silos of staff that do not talk to each
  other organization unable to respond to market
  changes evolution of fiefdoms which engender
  internal conflicts rather than problem solving
• Knowledge Organism dynamic processes that
  respond quickly to market changes flexible and
  ever-evolving
• Assisted by Web-based technology share
  information and work as a team to solve common
  problems

43
Why are Silos Problematic?

• Rigid Thinking Management that is part of the
  problem cannot be part of the solution
• Information that is necessary for solution not
  available in silo in most problems, you need
  new information or new way to think about problem
  in order to solve it. A silo thinks as
  follows-
• We know all the problems and all the solutions -
  the new guy is only trying to impress us
• New solutions are not invented here, therefore it
  cannot be right
• New solutions prove that we are wrong, therefore
  we must be against it, even if it is right
• We will lose our jobs if new thinking or process
  comes (self-interest)
• If costs us too much to try and learn new tricks
• Silos get caught up in their process and forget
  what their objective is. Bureaucraticism is
  order for orders sake, forgetting that order is
  to serve the people.

44
The Four Philosophies of Managing
Managing by Control
Managing through Coordination
Managing through Web Energizing structure
Allocation
set
set
set
set
hub
web
set
chain
In the set, managers look it over - they allocate.
In the chain, managers lay it on - they control.
In the hub, managers draw it in, they
coordinate.
In the web, managers link it all, they energize.
45
Paper-based Organization

• File sequential passing of information, giving
  history of case, moving up and down change of
  command Red tape paper database
• Outcome staff assumes that all information is
  in file. Tendency not to think out of the box.
• Wait for the boss to decide or wait for next
  piece of information
• Delays not able to respond to environmental
  changes quickly
• File can only be handled by one person at a time
• Paper-based systems easily become silos.

46
Web-based Organization

• File dynamic simultaneous exchange of
  information, enabling all staff to access global
  information and knowledge
• Outcome staff overloaded with information
  demands staff who know how to sort out important
  from urgent
• Faster process, but Delays and lack of due to
  Confusion not sure who is responsible, since
  everyone on cc list
• Full use of ICT technology and tools
• Requires staff to make critical judgment on
  cut-off for decision-making - but the more
  broad-based the judgment of staff, the more
  flexible and responsive functional
  maneuverability).

47
From Organization to OrganismAndrew Fenning J
Walter Thompsom

• One of the consequences of the Information Age
  is an ever-greater reliance on people and their
  unique skills of creativity, intuition, judgment
  and decision taking.
• We must transcend the silos, break the shackles
  that restrict our movement, enfranchise our
  employees.
• Fear of failure is the greatest destructive
  agent in our midst. That and paralyzing
  conformity.

48
Example How SFC implements Corporate Plan

• Six Strategic Initiatives
• Implementation of New Securities Law
• Implement Financial Infrastructure Blueprint
• Improve Corporate Governance
• Facilitate HK market development
• Strengthen Mainland-HKSAR cooperation
• Monitor industry changes
• Key to success is people - people make the
  difference

49
Identify Important Problems...

• Poor Corporate Governance - change law and
  clarify role of regulators
• Introduce Dual Filing
• Push for Greater Transparency and new Listing
  Rules
• Outmoded Intermediary Structure - identify scale
  of problems (overcrowded market, margin
  financing, obsolete paper-based infrastructure,
  etc)
• Demutualize Stock Exchange
• Fix problem brokers
• Outmoded processes - change through technology,
  speed up licensing and enforcement
• Tell everyone - better investor education,
  corporate communications and staff communications

50
Illustration Risk-based Regulatory Approach

• Tao
• Are our policy objectives clear?
• Heaven
• Do we know what risks the industry is facing?
• How good is our data?
• Earth -
• Do we have enough resources?
• Generalship
• Are our people experienced to tackle the
  problems?
• Law/Incentives
• Are we enforcing enough?

51
Judgment How to scale risks vs costs of
enforcement

• Stealing cases
• Low cost to detect, quick action with CCB
• E.g. China Logistics

• Complex deals
• High cost to investigate may require derivative
  action by SFC
• Mandarin Resources

High Gains
? Gains to miscreants

• Minor Infractions
• HKEx to enforce through Listing Rules,
  Intermediaries better Corporate Governance

• Unfair deals
• Minority shareholders complain, but high cost to
  investigate correct
• E.g. Oxford

Low Gains
Low Costs
High Costs
Costs of Enforcement ?
Source/footnote
52
Learning from FSA (UK)

• How do the best regulators approach this problem?
• Are they clear in their Regulatory Objectives?
• What methodology do they use?
• Can we adapt to Hong Kong conditions?
• Do we have the data on the risks involved?
• Can we measure the Regulatory Outcome?
• If in doubt, ask and learn!

53
Firm risk assessment
54
Pick Important Problems Tackling Risky Brokers

• Policy -
• Protect the investor, brokers can come and go
• Timing
• Do we wait for brokers to fail? or
• Should we have a preventive strategy?
• Terrain
• Lets map out the industry wide and firm level
  risks Engage PWC and ODriscoll Expert
  consultancy to give staff confidence in tackling
  problem
• Command
• How do we prioritize the issues?
• Law/Incentives
• Can we tackle this alone?

55
Fix them.

• Identify the risks -
• Financial Margin Finance
• StructuralPooling
• Conduct..Integrity
• Systemic.Contagion
• Timing
• Fast Solution
• Phased Solution
• Wait See
• Terrain
• Whats the size of the problem?
• Law/Incentives
• Who owns this problem?

56
Identifying the Risks Zoom in from Macro to
Micro

• Size of Industry - HK50 bn
• Capital HK24 bn (47 CAR) broadly solvent
• Margin Finance exposure 264 brokers with HK12
  bn margin loans, financed by HK3.3 bn bank loans
• Margin shortfall (black hole) ? HK800 mn,
  Compensation Fund HK800 mn (enough to fill
  hole)
• Problem Brokers
• PwC - 39
• ODriscoll 17 (client securities pledged 2.1
  bn)
• Secured bank debt 577 mn)
• SFC own analysis 14
• Critical watch list 3 or 4
• Number of Active margin clients 64,000 (26,000
  in 17 identified problem brokers)

57
We need Allies to solve this problem

• Can the problem be solved by Department alone? -
  No!
• Can SFC alone solve the problem? No!
• This is a systemic and historical problem that
  can only be solved by the whole community so we
  must find Allies-
• HK Government must back the solution Financial
  Secretary, Financial Services Bureau, Department
  of Justice
• Good brokers stand to gain by eliminating risky
  competitors
• Banks and HKMA stand to gain from a healthier
  financial sector
• Legislative Council needs to change laws and
  rules
• Investors need to understand investor
  education
• Media and Opinion Makers must understand and
  support
• Everyone stands to gain from a good solution
  but they must be convinced that it is in their
  interest.tell everyone!

58
None of us is smarter than all of us
Skills of C
Problem
Skills of A
Skills of B
A, B or C do not have knowledge or skills to
solve problem alone.
59
Time, Terrain Tactics

• Russian solution to Six Day War
• A legacy problem cannot be solved overnight
  therefore we need time and resources to solve it
• Offensive Tactics Market Product Development
  get the industry revenue up
• Defensive Tactics Through improvement to
  Financial Infrastructure re-engineering
  regulatory processes to reduce costs to industry
  (make industry more competitive)
• Deterrence Tactics - Enforce, Identify, Isolate
  and then Eliminate problem registrants
• Have a 3-year (2001-2004) game plan focus on
  the outcomes
• Every division within SFC has a key role!

60
Concluding Thought

• Never tell people how to do things. Tell them
  what you want them to achieve, and they will
  surprise you with their ingenuity.US Gen.
  George Patton

61
Next Lecture

• Lecture 1 A Macro-History of Chinese Governance
• Lecture 2 Theory and Practice of Governance
  Lecture 3 Leadership in Regulatory Environment
  Lecture 4 Money, Property Rights and Markets
• Lecture 5 Practice of Financial Regulation
• Lecture 6 A Property Rights Framework
• Lecture 7 Practice of Bank Supervision
• Lecture 8 Asian and International Financial
  Markets
• Lecture 9 The Regulation of Listed Companies
• Lecture 10 Consolidated Financial Regulation

62
Thank You
Questions to as_at_andrewsheng.net