Monetary Authority Chief Executive Joseph Yam reminds investors to exercise caution and prevent imprudent market behaviour when times are good.

In his weekly Viewpoint column published today Mr Yam said good times often encourage unwise behaviour as market participants get overzealous.

He said developed economies, particularly the US, have been on a sustained trend of expansion with relatively low inflation since the events of September 11, 2001.

"The financial markets have been performing well, with (until recently) declining volatility encouraged by interest rates being kept fairly low. The global macroeconomic environment and monetary and financial conditions have been unusually benign for a rather long period. This has led to higher appetites for risk, a search for yield and rising leverage among financial institutions, investors and borrowers."

Mr Yam said the sustained low-interest-rate environment also encouraged investors and financial intermediaries to search for yield, leading to a significant compression of yield spreads that may not have adequately reflected the additional risks being taken.

"The reduction of volatility, measured by the historical performance of financial markets over the period, also lowered the perception of risk. This encouraged an increase in risk appetites and, at the same time, a general decrease in attention to the possibility that potential volatility could differ considerably from the actual observed volatility."

Mr Yam said there was also an increase in leveraging by investors to boost absolute return and by financial intermediaries to improve profitability, exposing both to greater market and liquidity risks and increasing the probability of disorderly unwinding.

"Borrowers were also encouraged by the low interest rates and sustained economic expansion to run their businesses with higher leverage and therefore greater dependence on credit, making them more vulnerable to a sudden tightening of credit conditions."

Watch for weakness

Mr Yam said people should look for structural weaknesses in the city's financial system during good times.

The authority is conducting a review of how it can best discharge its responsibilities for promoting the safety and stability of Hong Kong's banking system.