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The research underlying this volume began with a question: why do financial crises occur and what can be done to prevent such crises and reduce their impact when they do occur? Today, following a series of financial crises around the world over the past fifteen years, this question to some extent has been answered through the establishment of a system of international standards directed towards the overall goal of financial stability. If one is interested in financial crises, it follows that one is also interested in the broader role of the financial system: clearly, financial crises are deleterious to economic growth, but can the financial system also have positive effects? Likewise, this question is now generally answered in the affirmative: an effectively functioning financial system is important for economic growth, though (as demonstrated by the existence of financial crises) finance also brings risks. The question then becomes how to develop a financial system which supports economic growth (and thereby economic development) in the context of financial stability. The purpose of this volume is to address this question.
In the past fifteen years, the recognition of the importance of law in an economy has increased greatly. It is now commonly accepted that property rights,enforcement of contracts and the rule of law are significant for economic development. Unfortunately, in most cases, the literature – especially the economic literature – has still not progressed significantly beyond this basic realization. The question arises: what do these ideas mean in practice? More precisely, if law is important, what sort of legal infrastructure and institutions are best?
This volume attempts to answer this question in the context of the financial sector – arguably the area of an economy in which law has the greatest importance. Specifically, this volume discusses the relationship among law, finance, and economic growth and development. It argues that law and the related institutional framework are fundamental to economic development generally. Further, it argues that an effective financial sector is essential to economic growth. On this basis, the volume addresses the question of how laws and institutions should be designed in order to support financial sector development to underpin economic growth in the context of financial stability.
In order to do this, the volume analyses international responses to financial crises in developing, emerging and transition economies1 at the end of the twentieth and beginning of the twenty-first centuries. The volume argues that financial crises since the Mexican crisis in 1994 have caused a fundamental re-evaluation of the role of financial law and institutions, with the consequent development for the first time of a comprehensive framework of internationally acceptable standards delineating minimum requirements for financial stability.
The author argues, on the basis of recent research, that law has a fundamental role in both financial stability and financial market development, both of which, in turn, are significant for economic growth. The volume analyses the international consensus (formalized through a series of international standards) respecting financial stability which developed following the series of financial crises around the world at the end of the twentieth century. It combines the elements of the key standards which have been developed with research respecting financial development in an effort to provide an understanding of the main legal and institutional elements supporting financial sector stability and development.
The volume discusses whether the international financial architecture, as currently structured, addresses the risks inherent in moving from a closed domestic financial system to an open system integrated into the global financial system. It suggests that the current structure of the international financial architecture has developed as a response to the risks inherent in financial liberalization, domestic restructuring and globalization of finance. However, unlike the structure developed at Bretton Woods at the end of World War Ⅱ or in the European Union, the current structure of the international financial architecture fails to explicitly link domestic restructuring (addressed by the current matrix of international financial standards) with financial libera-lization (especially in the context of both capital account liberalization and the role of the World Trade Organization [WTO]) and globalization of financial markets (and the role of the international financial institutions in this process). Further, it fails to move coherently beyond the requirements of stability to the requirements of development.
The volume concludes by suggesting that individual governments, regional arrangements and development organizations should take an active interest in the legal and institutional design of financial systems, much in the way that one would pursue major construction or technological development projects, to support financial stability in the context of financial development and in order to enhance economic growth and development.
Following this introduction, the volume proceeds through ten chapters organized into four parts.
FINANCIAL MARKETS AND THE INTERNATIONAL FINANCIAL ARCHITECTURE
The first part discusses the relationship among law and institutions, financial sector development and economic growth, and the international financial architecture.
The part begins, in the first chapter, with a discussion of theories of economic development, suggesting that there is an emerging consensus relating to the importance of an economy’s institutional framework, including law and legal infrastructure, in economic growth and development; presents research addressing the role of law in an economy; and argues that law and legal infra-structure have an important role in economic growth, development and finance. The chapter highlights three aspects: first, the fundamental role of law and institutions in economic growth and development; second, the growing body of research suggesting that an effective financial system is necessary to support economic growth; and third, the role of law and institutions in an effective financial system. Second, the chapter discusses the role of finance in economic growth and development, suggesting that the role is both positive and negative. Financial crises and research have highlighted weaknesses in both domestic and international financial systems, as well as the significance of the financial sector – both positive and negative – in economic growth and development more generally. In order to discuss the role of law in financial development, it is first necessary to have a general understanding of the financial sector, what it does, and how it works. The chapter therefore includes a brief introduction to financial systems. This picture of financial systems, however, is only a stylized description, both of domestic and international financial systems. Finally, the chapter also looks at the function of law in finance, and concludes by suggesting that law plays an essential role in financial development, which, in turn, is significant for economic growth and development generally.
The second chapter of this volume discusses the developing international framework addressing the potential negative impact of finance on economic development – namely, the concepts of financial stability and the international financial architecture. It addresses financial stability, its role and the central issue of whether the international financial architecture as currently structured addresses the risks of participation of individual economies, especially developing, emerging and transition economies, in the global financial system. It argues that appropriate law and legal infrastructure are a necessary but not sufficient component of financial stability, economic growth and development. Specifically, Chapter Two discusses financial stability and the significant but incomplete international consensus that has developed in the past decade. This consensus is often discussed in the context of the “new international financial architecture”. With this international framework in mind, the remainder of the volume addresses the mechanics of legal infrastructure in finance.
The chapter first looks at the post–World War Ⅱ design for international financial stability and economic development: the Bretton Woodsinternational economic system and its objectives (financial stability and economic development, based on three pillars: money, finance and investment, and trade). Second, it briefly discusses the changes in the international financial system between the creation of Bretton Woods and the end of the twentieth century: the process of financial market globalization.
The onset of the Mexican financial crisis in 1994 signaled the return of a sort of financial crisis not seen since before the establishment of the Bretton Woods system and its structure of fixed relationships among closed domestic financial systems. Prior to 1944, however, such crises were not uncommon and, in fact, one goal of the design of the Bretton Woods system was to eliminate the possibility of similar financial crises in the future. In many ways, it was remarkably successful; however, following the break up of the fixed exchange rate system in 1973, the gradual return to free movement of capital and the increasing re-integration of financial systems, the stage was set for a return to the sorts of crises common during the nineteenth and early twentieth centuries. Financial crises in emerging economies around the world over the past fifteen years highlight the dangers inherent in financial liberalization without adequate domestic restructuring in the context of participation in increasingly an globalized financial system.
Third, the chapter analyses the international response to the string of financial crises over the past fifteen years: discussions regarding the international financial architecture and the development of a system of international financial standards, comprising the political framework, international financial standards themselves, standard setters and setting, implementation, and monitoring. As a direct result of the Mexican and east Asian crises, the Group of Seven (G-7) and the Group of Ten (G-10) (among others) analysed the causes of and appropriate responses to similar situations in the future. The G-7 issued directions based on the analysis to the international financial organizations and institutions – a pattern that has since solidified into a methodology, perhaps even a system. In regard to financial stability, the G-7 issued directions to international financial organizations (e.g., the Basel Committee on Banking Supervision) to develop standards to address domestic financial sector weaknesses, which were a significant underlying factor in the various crises of the 1990s. The international financial institutions (especially the Bretton Woods institutions) are charged with supporting implementation and monitoring of those standards. In addition, the international financial institutions were directed to implement emergency measures to be used in future crises. The result is the only development respecting the international financial architecture which can really be called “new”: a system of international financial standards under which political decisions are taken by the G-7; standards are formulated by international financial organizations; coordinated by the new Financial Stability Forum; and international financial institutions develop mechanisms of implementation, monitoring and response to crises, with the result being translation of international standards into domestic legal systems.
In essence, a system of international financial soft law based on implementation and monitoring of nonbinding standards has been added to the existing international financial architecture. Unfortunately, the system of international financial standards, while significant, does not form a coherent system in the same way as the Bretton Woods system as designed (though not as implemented). The system is designed to address the same issues as the Bretton Woods system (stability and development), but does so in an incomplete manner and, thus, the existing international financial architecture needs to be reviewed in order to appropriately address all three pillars in a coherent and integrated system. The chapter concludes that the current structure of the international financial architecture fails to adequately address the realities of globalized financial markets and that individual countries should undertake coherent reform processes as part of the process of financial integration and development, albeit using the system of international financial standards as a starting point.
From this background, the second and third parts of the volume analyse the specific elements of the legal and institutional framework for a stable and effective financial sector. Specifically, parts two and three discuss the main issues to be considered in financial stability and development, on the basis of international standards and related research. The system of international standards focuses on fifteen “key standards for sound financial systems”, organized under three broad headings and twelve key subject areas. The first broad heading, macroeconomic policy and data transparency, is the responsibility of the International Monetary Fund; the second and third (institutional and market infrastructure, and financial regulation and supervision) are the responsibility of a wide variety of different standard-setting organizations. The chapters look at the main elements of the consensus respecting financial stability and summarize research addressing the role of law and institutions in financial market development in an effort to outline the appropriate institutional framework for finance, reflecting current international best practices.
FOUNDATIONS OF FINANCIAL SECTOR DEVELOPMENT
Part II discusses the foundations of financial stability and development. Specifically, we look in Chapter Three at the preconditions for finance – the fundamental elements necessary for finance to develop and function, namely: (1) foundations of financial development and economic growth and (2) institutional underpinnings of finance. Chapter Four, in turn, deals with the role of central banks in financial, monetary and macroeconomic stability. While the system of international financial standards addresses the third area (reflecting an immense amount of research outside the scope of this volume), it does not address the first and second, even though, in fact, foundations and institutional underpinnings may be of at least as great, if not greater, significance for finance and development than macroeconomic policy.
Building on recent research, Chapter Three argues that financial systems require certain legal and institutional elements to be in place in order to function. These include property rights, collateral frameworks and company law, which, in turn, must be set in a framework supporting effective governance providing for enforcement of contracts and commercial dispute resolution. In addition to these institutional foundations, financial sector development occurs best in the context of a stable macroeconomic setting, including appropriate monetary, financial and fiscal policies and frameworks (Chapter Four). In addition, Chapter Four addresses certain responsibilities of central banks and financial authorities, including payment and settlement and government bond markets.
Chapter Five discusses the elements of institutional and market infrastructure which are essential to support the development of an effective, functional financial system. These elements – all addressed by international financial standards – build upon the underpinnings discussed in Chapters Three and Four and are necessary for the financial regulatory systems and structures discussed in Part III to function properly in a market economy. Building on these foundations, Chapter Five looks to the many sorts of legal infrastructure necessary for sophisticated financial systems to function properly – what could be called essential financial infrastructure. It therefore considers the supporting institutional and market infrastructure which is necessary for sophisticated financial systems to develop. Aspects include insolvency regimes, corporate governance, and accounting and auditing systems (“financial information”). These are supported by appropriate measures to protect market integrity and thus confidence in the financial system. It is only when both the foundations and the supporting infrastructure are in place that financial liberalization, regulation and supervision can function properly.
FINANCIAL REGULATION AND SUPERVISION
Part III discusses a central focus of recent international efforts: financial regulation, supervision and liberalization. Specifically, it investigates the primary areas addressed by the system of international financial standards: banking (Chapter Six), nonbank finance (Chapter Seven), and financial liberalization and related issues such as financial conglomerates and financial regulatory structure (Chapter Eight). International financial standards, however, generally only address stability and not the role of development. The volume attempts to take both into account and to consider other areas meriting further attention.
Part IV discusses deficiencies in the international financial architecture as currently structured and in the process through which economies address their financial sector legal and institutional frameworks. The volume concludes, first, that international financial standards constitute a necessary but not sufficient requirement for financial stability. Second, the current pseudo-system is inadequately structured to deal with the central issue presented at the outset – that is, the relationships among the requirements for development (namely, liberalization, restructuring and integration), especially as the system discussed interacts with the WTO and its constituent financial services provisions. Third, the current structure of the international financial architecture does not adequately address the issue of crisis resolution.
The final two chapters thus look forward and address the reform of the international financial architecture and financial systems. They focus on the role of the international financial architecture discussed in preceding chapters, including weaknesses of the current system and a brief agenda for possible reform, and discuss issues which need to be considered in developing fully effective financial systems but to date have not been adequately treated by the international financial architecture, including development (especially competition and its relationship to the international framework of the WTO), the interaction between liberalization and regulation, and the systemic context.
Chapter Nine suggests, first, that the system of international financial standards (with its focus on financial stability) does not adequately address certain issues, especially those related to development. It argues that although the system of international standards addresses financial stability comprehensively, it does not address the issue of development to any great extent. In this regard, as standards are revised, developmental issues should be addressed in addition to stability requirements. Further, at present, international standards do not adequately address issues of competition. Especially significant is the fact that the WTO framework governing financial services access has not been incorporated into the system of international financial standards.
Second, chapters nine and ten suggest that, unlike the Bretton Woods or EU structures, the current system of international standards does not adequately address the interlinkages between finance and the international architecture. Specifically, they argue, first, that the current system of financial standards does not address the important issue of the relationship between financial liberalization and financial stability, even though this relationship is addressed by the more formal structure of the EU single financial market project. In addition, as discussed previously, financial systems today have the added complication of their interaction with one another. As a result, economies must consider issues respecting interaction and integration with global and regional financial systems. Unfortunately, the current system of financial standards does not address the important issue of the relationship between financial liberalization and financial stability at a global level. However, this relationship has been addressed at a regional level by the more formal structure of the European Union, which may provide a model for both international and other regional arrangements. Second, the international financial architecture still does not address adequately issues of crisis resolution.
The final chapter discusses financial sector design, including financial and regulatory structure, and a suggestion that individual economies proactively support financial sector development and stability by addressing the legal and institutional framework of their financial and economic systems on a holistic basis in order to achieve the desired results of financial stability and development. Governments may consider a variety of models available for domestic financial structure and for regulatory systems. If law and institutions are important for stable and effective finance, how can officials take advantage of research and best practices in their own systems and what can development professionals and organizations do to assist? The chapter suggests that financial sector development indeed can be influenced and recommends careful analysis and planning by governments and their advisors in order to appropriately address issues of legal infrastructure in financial development in order to secure economic development.
Unfortunately, despite much effort, financial crises continue, with dramatic consequences for development. The volume argues that the current framework provides an important starting point but that significant deficiencies remain. In order to support financial stability, economic growth and economic development, a fresh look should be taken at the international financial architecture in the context of the realities of today’s global financial system.
This book has been supported by my interactions with a wide range of individuals and organizations around the world. While it is impossible to acknowledge all of these influences (and I am vastly appreciative of all those I have worked with on related issues over the years), I would like to especially thank the following for their input, support and/or thoughts on related issues: Ernesto Aguirre, Noritaka Akamatsu, James Barth, David Bernstein, William Blair, Charles Booth, Ross Buckley, Joao Farinha, Stefan Gannon, Say Goo, Jorge Guira, Christos Hadjiemmanuil, Vanndy Hem, Angela Itzikowitz, Lolette Kritzinger-van Niekirk, Rosa Lastra, Jing Leng, Julia Leung, José de Luna, Donald McIsaac, Matthew Morgan, Christopher Olive, Jae-Ha Park, Anita Ramasastry, Keith Reid, Gerard Sanders, Norbert Seiler, Heba Shams, Andrew Sheng, Marc Steinberg, Tull Traisorat, George Walker, Wei Wang, Mamiko Yokoi-Arai, Said Zaidansyah, and Zhongfei Zhou.
I would also like to thank the present and former staff of the Asian Development Bank, European Bank for Reconstruction and Development, International Monetary Fund and World Bank, as well as my present and former colleagues at the University of London and the University of Hong Kong.
In addition, I would like to thank Mads Andenas, Charles Chatterjee, Ross Cranston, Chantal Hébert, Paul Lejot, Joseph Norton and Michael Taylor for comments on various drafts. Finally, I would like to thank John Berger, Mary Cadette, Linda Smith and the staff of Cambridge University Press for their highly professional support and production.
All errors of course are my own.
Douglas W. Arner