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Financial Market Regulation and Reforms in Emerging Markets
BROOKINGS INSTITUTION PRESSCopyright © 2011 ASIAN DEVELOPMENT BANK INSTITUTE
All right reserved.
Chapter OneFinancial Sector Regulation and Reforms in Emerging Markets: An Overview
ESWAR S. PRASAD
The speed and breadth of contagion from the U.S. financial crisis have dramatically demonstrated the degree to which national economies, developed and developing alike, are intertwined. Initially a problem confined to the U.S. housing market, the rapid spillover of the crisis to the rest of the U.S. financial system and then to the global economy left financial institutions in other advanced economies reeling. The crisis has highlighted the need for substantive regulatory reforms geared toward ensuring the integrity and resilience of financial systems in the advanced economies.
The macroeconomic consequences of the crisis have also affected emerging markets and other developing economies, even though these groups have rebounded more quickly and sharply from the crisis. These shared ramifications have brought into even sharper relief the centrality of sound financial systems for emerging markets as well as low-income developing economies. Efficient and stable financial systems are essential for both emerging markets and low-income developing economies to achieve long-term balanced development and to absorb various types of shocks.
It is striking that the crisis emanated from the United States and hit a group of economies particularly hard, including that of the United Kingdom, that were once believed to have the most sophisticated and robust financial systems. These developments have necessitated the reevaluation of basic principles of financial regulation. Clearly, existing regulatory models and frameworks need to be reconfigured and strengthened. The necessary paradigms are still evolving, although there appears to be a general consensus on some key principles that will be central to a major redesign of financial regulation.
Emerging market financial systems, including those in Asia, have generally proven to be more robust and less affected by the global turmoil than their more advanced economy counterparts. It will be important to carefully filter out the right lessons from this outcome. Meanwhile, the imperative of financial development remains as strong as ever in emerging markets, although the focus is more on basic elements, such as strengthening banking systems and widening the scope of the formal financial system, rather than on creating sophisticated instruments and innovations.
Emerging markets face particular challenges in stabilizing their nascent financial systems in the face of shocks, both domestic and external. These challenges occur at a basic level in emerging markets, many of which are at the point of creating sound banking systems, widening inclusion in the formal financial system, and creating and managing a broader set of financial markets (such as corporate bond markets and basic currency derivatives). Thus the regulatory challenges in these economies are more about risks emanating from underdeveloped financial systems rather than risks from sophisticated financial innovations.
New paradigms for financial development and regulation will have to be suitably reframed for emerging markets, which have a number of varying institutional and capacity constraints. Regulation in low-income countries, where the breadth of formal financial systems is severely limited, poses an even greater set of conceptual and practical challenges.
Policymakers in emerging markets will need to grapple with a distinct set of issues once the recovery in the global economy is entrenched and attention can turn to the steps needed to restore financial stability. The following are some of the key issues facing policymakers and regulators in emerging markets:
What lessons does the crisis offer for the establishment of efficient and flexible regulatory structures? Even advanced economies have had to confront these deep structural questions, which tend to be more complex in emerging markets due to inadequate regulatory capacity and weak legal and public institutions.
How can the regulatory and financial development agendas be reconciled in a manner that creates regulatory space for the introduction of standardized products and the development of broader financial markets while effectively managing the associated risks? The financial development agenda is an important one in emerging markets where efficient financial intermediation remains a major challenge, with implications for general economic welfare.
Is broader financial inclusion consistent with financial stability? In general, increasing financial inclusionextending access to the formal financial system to a greater swath of the populationis a key issue for emerging markets at this critical juncture of their economic development. Financial inclusion has many implications for allowing households to save and diversify their sources of income, enabling entrepreneurs to have access to financing, and creating a more efficient system of intermediating domestic savings into investment.
What avenues should be pursued to enable effective regulation of financial institutions with large operations in multiple countries? Foreign banks and other financial institutions have become key players in many emerging markets and have provided a number of direct and indirect benefits to local financial systems. However, in times of externally induced crises, they may prove to be a source of contagion.
This chapter focuses on evaluating the lessons from the crisis and on designing effective strategies for maintaining the momentum of financial development and inclusion in emerging markets, with a particular focus on Asian emerging markets. It attempts to assess the implications of the financial crisis for the design of regulatory frameworks and models, taking into account the specific constraints in emerging markets. The main areas covered in this paper are:
Basic principles of financial regulation: synthesizing evolving paradigms on the key characteristics of optimal regulatory structures to promote financial stability.
Financial regulatory reforms in emerging markets, with a focus on emerging Asia: dealing with the challenges of limited institutional development and regulatory capacity.
The financial development agenda: improving financial intermediation and creating space for the development of broader financial markets, including basic derivative products.
Financial inclusion: how to increase the access of households and entrepreneurs to the formal financial system in emerging markets and considerations of whether greater inclusion is consistent with promoting sound regulation.
Optimal macroeconomic policy frameworks to enhance financial stability: challenges in designing robust monetary policy frameworks, particularly in light of de facto increasingly open capital accounts.
Cross-border financial regulation and, more broadly, regulation of financial institutions that have a substantial presence in emerging markets.
Basic Principles of Financial Regulation
Before the financial crisis, the debate about optimal regulatory structures was focused narrowly on a few issues. One aspect of the debate was whether the United Kingdom's single regulator model, as embodied in the Financial Services Authority, was better than the multiple regulator framework of the United States, where different agencies have varying jurisdictions. The crisis has exposed gaping weaknesses in both models. The Financial Services Authority was responsible for overall financial stability but appears to have regulated with a "light touch," allowing large levels of systemic risk to build up in the system. In the United States, regulatory failures were compounded by gaps in the overall framework for supervision and regulation that left some products and markets relatively unregulated and created large opportunities for regulatory arbitrage.
A different angle to this issue is the contrast between rules-based and principles-based regulation. Rules-based regulation, which emphasizes getting the regulated to obey the letter of the regulation, typically involves more direct control by the regulatory authority and has been the preferred mode in emerging markets. It had been argued that principles-based regulation, which emphasizes getting the regulated to adhere to the spirit of the regulation, is more appropriate for advanced financial markets. But it also may be relevant for emerging markets looking to develop their financial markets by opening them up to more innovation and risk taking. The crisis has shown that both approaches, which tend to be based on microprudential regulation of individual financial institutions, may be insufficient for dealing with systemic risk.
A reconsideration of basic principles is needed for designing an effective and flexible regulatory mechanism that is capable of dealing with financial innovations and systemic risks. In the wake of the financial crisis, a number of reports have been commissioned from various bodies to look into regulatory reforms. These reports generally agree on some core principles that will have to be emphasized in any set of reforms.
Higher Capital Requirements
One clear impact of the crisis has been to increase the desirable levels of capital buffers held by financial institutions. The U.S. Treasury has enunciated a set of core principles for capital and liquidity requirements for financial institutions, including the following three principles:
Capital requirements should be designed to protect the stability of the financial system, not just the solvency of individual banking firms.
Capital requirements for all banks should be increased from present levels and should be even higher for financial firms that pose a threat to overall financial stability.
Banking firms should be subject to a simple, non-risk-based leverage constraint and also to a conservative, explicit liquidity standard.
Major advanced economies are considering a reevaluation of assets that can be counted as tier one capital as well as the use of an equity capital standard.
Higher-quality forms of capital that enable banking firms to absorb losses and continue as going concerns should provide for a more effective first line of defense for those institutions and limit systemic spillovers. The Treasury report also notes that stricter capital and liquidity requirements for the banking system should not be allowed to result in the reemergence of an underregulated nonbank financial sector that poses a threat to financial stability. Determining appropriate capital adequacy standards for the shadow banking system will be a key challenge in an effective redesign of the regulatory system.
Indeed, another key challenge is to ensure that capital requirements for banks and other highly regulated entities do not result in their simply shifting activity to less regulated areas, including off-balance-sheet activities such as structured investment vehicles. This would simply encourage more risk-taking and raise systemic risk as well, since many off-balance-sheet activities could end up being effectively on-balance-sheet in times of crises.
Countercyclical Provisioning and Acyclical Accounting Standards
In addition to higher capital requirements, the nature of capital requirements will have to be reevaluated to ensure that they do not intensify systemic financial distress. Existing risk-weighted capital requirements can sometimes exacerbate financial panics by requiring financial institutions to raise capital by selling assets into falling markets. The alternative of a countercyclical capital requirement, however, creates complications in terms of defining and measuring the business cycle. Even in relatively calm periods, it is not easy in real time to distinguish between trends and cyclical movements in output, and this becomes even more difficult as a practical matter in emerging market economies where business cycles tend to be more persistent.
On the other hand, the dynamic provisioning approach adopted in Spain appears to have had some success as it facilitates earlier detection and coverage of credit losses in loan portfolios. This enables banks to build up buffers against cyclical downturns, thereby increasing the resilience of individual banks as well as the banking system as a whole, a consideration that is particularly relevant for emerging market economies with bank-dominated financial systems. In addition to some form of countercyclical capital requirements, accounting standards will have to be reconsidered so that they do not further intensify systemic problems. But it will be equally important to preserve some notion of forward-looking fair market value in developing new accounting standards.
Liquidity Risk and Leverage
Following the crisis, these are concepts that will need to be given careful consideration in the regulatory process. Regulators will need to establish parameters for financial firms to manage liquidity risk and limit leverage, especially as the latter can heighten counterparty risk in the financial system. It is important in this context to note that it is not just banks but other financial institutions that because of their interconnectedness or sizewill need to have their liquidity risk carefully monitored. Constraining leverage at both the institution-specific and aggregate levels is necessary to ensure that excessive leverage at either of these levels does not create systemic breakdowns. Regulatory oversight of payment, clearing, and settlement systems can help ensure that they are not subject to failure as a result of the failure of one or two institutions with large counterparty exposures. Central counterparty clearing of large-scale transactions, rather than having all settlements take place between individual firms, could add further stability to these systems.
In assessing capital requirements on the basis of risk, it will be important to consider the broader relationship among credit, liquidity, and market risks. At times of crises, these risks can interact with and amplify each other. For instance, during the recent crisis, credit and market risks surged when liquidity dried up in financial markets. To deal with the impact of such feedback effects, capital requirements should take a broader view of risk and the relationships (and potential feedback mechanisms) among different sources of risk in the financial system. This implies that different aspects of risk must first be carefully considered at the level of the individual institution and then also analyzed at a broader systemic level.
This is a broad concept that includes substantive issues such as bringing more derivative products onto exchanges where they can be traded in a more transparent setting and thereby can be monitored and regulated more effectively. Large over-the-counter (OTC) derivatives contracts that raise counterparty exposure can elevate the level of systemic risk. Steps should be taken to standardize derivative products to the extent possible and improve the technical trading infrastructure in order to increase the incentives for financial firms and corporations to hedge various kinds of exposures on these exchanges rather than via OTC instruments. There could still be a place for certain types of OTC products, but these also should be brought into the regulatory net, and financial firms that are involved in these products should be subject to high capital requirements.
Macroprudential Approach to Regulation
The crisis has created a clear recognition of the need to evaluate and manage financial risks at the systemic level rather than at the level of individual institutions. In complex financial systems, where there is a high level of interconnectedness among financial institutions, institution-specific risk can quickly get transformed into aggregate-level risk. The solution is, in principle, to monitor institution-specific as well as aggregate risk. But a lot of work needs to be done on how to evaluate aggregate risk, especially in determining what sort of reporting requirements are needed to make proper assessments of the level of interconnectedness among different institutions within a system. The ultimate goal is to enable a systemwide approach for regulating systemically important institutions (based on their size, extent of leverage, interconnectedness with other institutions, and degree to which they provide financial services critical to the operation of key markets).
Coordination among Regulators
Following from the previous point, it is clear that closer coordination among different regulatory agencies as well as a careful analysis to close gaps that exist in the regulatory framework are essential. Many financial institutions are now complex and operate under multiple jurisdictions, including in some areas where regulatory oversight might be minimal. There is an increasing impetus in different economies to put in place an institutional setup to coordinate the work of different regulatory agencies and to provide oversight of the agencies themselves. For instance, the U.S. Treasury has recently mooted the idea of a Financial Services Oversight Council while the Rajan Committee made a similar recommendation to set up a Financial Sector Oversight Agency in India, a proposal that has recently been implemented by the government. There are some challenges in determining the authority of such an institution, particularly if it is subsumed under an existing regulatory institution.
Excerpted from Financial Market Regulation and Reforms in Emerging Markets Copyright © 2011 by ASIAN DEVELOPMENT BANK INSTITUTE. Excerpted by permission of BROOKINGS INSTITUTION PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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