Financial Market Regulation And Reforms In Emerging Markets

4 Highlightsmarkets. It had been argued that principles-based regulation, whichemphasizes adhering to the spirit of the regulation, is more appropriate foradvanced economy financial markets. But this approach also may berelevant for emerging economies looking to develop their financialmarkets by opening them up to more innovation and risk taking. The crisishas shown that both approaches, which tend to be based onmicroprudential regulation of individual financial firms, may beinsufficient for dealing with systemic risk.Some observers have identified four major market failures thatprecipitated the global financial crisis—excessive risk-taking by financialfirms under implicit government guarantees; regulatory focus onindividual firms rather than systemic risk; lack of transparency of financialfirms, products and markets; and proliferation of the shadow bankingsystem. Policymakers need to identify the source of market failures firstand then design regulations to specifically address those market failures.Furthermore, striking the right balance among goals, such as reducingsystemic risk, protecting innovation, and maintaining political feasibility,is an important priority for the design of these policies.One clear impact of the crisis is the consensus that has developed onthe need to increase the levels of capital held by financial firms. The BaselCommittee on Banking Supervision has proposed tighter capitalrequirements for banks, including higher levels of Tier 1 capital, a higherratio of core Tier 1 capital, a capital conservation buffer and acountercyclical capital buffer. These regulatory requirements are to bephased in over a number of years although it is likely that markets willbegin to use Basel III requirements as benchmarks even before theirofficial implementation. Higher capital ratios and higher-quality forms ofcapital that better enable banking firms to absorb losses and continue asgoing concerns in the face of adverse financial and macroeconomic shocksshould provide for a more effective first line of defense for those banksand limit systemic spillovers.Stricter capital and liquidity requirements for the banking systemshould help to prevent the reemergence of an under-regulated nonbankfinancial sector that poses a threat to financial stability as a result of shiftsof financial activity to outside the regulatory perimeter. Determiningappropriate capital adequacy standards for the shadow banking system will

Financial Market Regulation and Reforms in Emerging Markets 5indeed be a key challenge in an effective redesign of the regulatory system.A related challenge is to ensure that tighter capital standards for banks andother highly regulated entities do not result in these firms simply shiftingtheir activity to less regulated areas, including off-balance-sheet activitiessuch as structured investment vehicles. Such a shift would simplyencourage more risk taking and raise systemic risk as well, since many offbalance-sheet activities could effectively end up on-balance sheet in timesof crises.In addition, the nature of capital requirements will have to bereevaluated to ensure that they do not tend to amplify systemic financialdistress. Existing risk-weighted capital requirements can sometimesreinforce credit booms by allowing financial firms to expand credit in goodtimes, as well as exacerbate financial panics in times of crisis by requiringfinancial firms to raise capital by selling assets into falling markets. Thealternative of a countercyclical capital requirement, however, createscomplications in terms of defining and measuring the business cycle. Evenin relatively calm periods, it is not easy in real time to distinguish betweentrend and cyclical movements in output, and this becomes even moredifficult as a practical matter in emerging economies where businesscycles tend to be more persistent.The dynamic provisioning approach adopted in Spain appears to havehad some success as it facilitates earlier detection and coverage of creditlosses in loan portfolios. This requires banks to build up buffers againstcyclical downturns, thereby increasing the resilience of individual banks aswell as the banking system as a whole, a consideration that is particularlyrelevant for emerging market economies with bank-dominated financialsystems. The Basel Committee’s proposal of a countercyclical bufferbased on “excess credit growth” that could reflect the buildup of systemwide risks appears reasonable and should alleviate some of these concerns.But it may be difficult to define excess credit growth in the case ofemerging economies whose financial systems are still developing, and thisapproach may still be subject to the problems of identifying unsustainablebooms in economic activity and credit aggregates.In assessing capital requirements on the basis of risk, it will beimportant to consider the broader relationship among credit, liquidity, andmarket risks. At times of crises, these risks can interact with and amplify

6 Highlightseach other. For instance, during the global financial crisis, credit andmarket risks surged when liquidity dried up in financial markets. To dealwith the impact of such feedback effects, capital requirements could bestructured to take a broader view of risk and the relationships (andpotential feedback mechanisms) among different sources of risk in thefinancial system. This implies that different aspects of risk must first becarefully considered at the level of the individual financial firm and thenalso analyzed at a broader systemic level.The crisis has created a clear recognition of the need to evaluate andmanage financial risks at the systemic level rather than solely at the levelof individual firms. In complex financial systems, where there is a highlevel of interconnectedness among financial firms, firm-specific risk canquickly transform into aggregate-level risk. The solution is, in principle, tomonitor firm-specific as well as aggregate risk. But a lot of work needs tobe done on how to properly evaluate aggregate risk, especially indetermining what sort of reporting requirements are needed to make properassessments of the level of interconnectedness among different financialfirms within a system. The ultimate goal is to implement a systemwideapproach for regulating systemically important institutions—identified assuch based on their size, extent of leverage, interconnectedness with otherfirms, and degree to which they provide financial services critical to theoperation of key markets.There is an increasing impetus in different economies to establish aninstitutional framework to coordinate the work of different regulatoryagencies and to provide oversight of the agencies themselves. For instance,the U.S. Treasury has recently set up a Financial Services OversightCouncil while the Rajan Committee made a similar recommendation to setup a Financial Sector Oversight Agency in India, a proposal that hasrecently been accepted by the government. There are some challenges indetermining the authority of such an agency, particularly if it is subsumedunder an existing regulatory agency.As discussed in the context of capital requirements, it is important toensure that tighter regulation in one area does not tend to lead to regulatoryarbitrage in the form of financial firms shifting the regulated activity toless tightly regulated jurisdictions. The financial crisis has shown thatoperations of unregulated entities have the potential to contaminate

Financial Market Regulation and Reforms in Emerging Markets 7markets and infect even highly regulated sectors in times of crisis. Thusthe systemic consequences of the operations of lightly regulated andunregulated entities will have to be taken into account as part of theprocess of overall regulatory coordination.An equally important priority is to increase transparency in financialmarkets. This is a broad concept that includes substantive issues such asbringing more derivatives products onto exchanges where they can betraded in a more transparent setting and, thereby, can be monitored andregulated more effectively. There are risks inherent in large over-thecounter (OTC) derivatives contracts that raise counterparty exposure andelevate the level of systemic risk. One approach to tackling this problemwould be to standardize derivatives products to the extent possible andimprove the technical trading infrastructure in order to increase theincentives for financial firms and other corporations to hedge various kindsof exposures on exchanges rather than via OTC instruments. There is still alegitimate role for certain types of OTC products and the challenge here isto ensure that the regulatory net covers these products and that financialfirms involved in these products are subject to high capital requirementsfor these activities. Transparency is about much more than reportingrequirements, however. It entails a careful reconsideration of accountingprinciples, the responsibilities of accountants, and concepts to match theincreasing sophistication of financial products and the risks embedded inthem.There are also basic conceptual and practical questions that need to beaddressed in the context of setting up the broad regulatory framework,including, for instance, whether it is appropriate for the central bank tohave responsibility for overall financial stability in addition to pricestability. In the United Kingdom, a decision was made to shift theresponsibility for overall financial stability, including the power to regulateand supervise individual financial firms, from the FSA to the Bank ofEngland (BoE). As a result, the BoE has acquired the dual mandates ofachieving both financial stability and price stability. In the United States,which ostensibly had an efficient regulatory system but was plagued byflaws in the multiple regulator model, a decision was made to give theFederal Reserve Board (Fed) expanded regulatory authority over large,systemically important (“too big to fail”) institutions. When this changewas proposed, enormous resistance arose because of fears of concentration

8 Highlightsof power with the Fed and also concerns about diluting its primaryobjective of pursuing price stability. Some observers pointed out thepresence of regulatory capture as regulators were considered subject tointense political pressure that led them to put the interests of financialfirms ahead of the general public interest. Although the Fed has no officialmandate to promote financial stability, it now has a considerable power todo so in addition to its official mandate of achieving price stability and fullemployment.Regulatory Frameworks for Emerging MarketsAlong with a reconsideration of basic principles, it will be important tothink about how to adapt these principles to the particular circumstances ofemerging market economies where there are significant institutional andcapacity constraints. Although country-specific conditions cannot beignored, it will still be useful to develop a framework for making progresson this issue.Many of the basic principles that are being formulated, includinghigher capital requirements and a focus on liquidity risk management, areas relevant for emerging markets as they are for advanced economies. Foremerging markets, it is also a priority to deal with institutional andcapacity constraints that limit effective regulation and hinder financialstability. Indeed, even basic microprudential regulation—the effectiveoversight of individual financial firms—can be a challenge for manyemerging economies. From the perspectives of both individual bankefficiency and regulatory stability, a key priority for financial firms inthese economies is to implement good risk-evaluation and riskmanagement practices on their loan portfolios.Policymakers in emerging markets recognize that a core priority is tostrengthen their institutional frameworks in order to promote financialstability. This includes instituting comprehensive insolvency procedures towind down financial firms and other corporations, and developing a morerobust legal framework to enforce property rights consistently and fairly.It has been argued that the global financial crisis originated from theinterplay among lax financial regulations that allowed financial firms to

Financial Market Regulation and Reforms in Emerging Markets 9take excessive risks, excessively loose monetary policy in major advancedeconomies, and global imbalances. Existing regulations were not adequatefor dealing with the rapid growth in derivatives and securitized credits inthe past decade. The growing shadow banking system contributed to theincreasing divide between the financial and real sectors. This yields anumber of policy priorities, including macroprudential regulations thatmitigate systemic risk, broader regulatory scope, greater capital andliquidity buffers, more effective risk management on the part of financialfirms, and stronger international coordination.It is interesting to compare China’s banking regulation and standardswith that of the Basel Core Principles for Effective Banking Supervision(BCPs). China’s practices could be characterized as rules-based while theBCPs are seen as principles-based. One could make the argument thatChina’s regulatory standards, while significantly influenced by the BCPs,are more prescriptive and specific and that this approach is more suitablefor emerging markets. A sound supervisory framework should be dynamicand reflect the realities of the financial sector for which it is created. Whilebest practices in advanced economies should be considered as a startingpoint for enhancing current supervisory frameworks, one should bear inmind that a single framework does not fit all types of financial firms orsystems.Another important issue is whether financial crises can be prevented,even if their precise timing cannot be predicted, by identifying and dealingwith sources of instability. Policymakers need to complement top-downmacroprudential supervision with microprudential supervision. Thisnecessitates adequate provision of liquidity by the central bank duringcrises and a clearly defined cross-border insolvency resolution mechanismfor failed global financial firms. At the national level, systemic crises arebest managed by a strong and comprehensive regulatory body.Latin American and Asian experiences show not only how valuablelessons can be extracted from crises but also how these lessons aresometimes forgotten over time. In the debt crises of the 1980s and 1990s, anumber of Latin American countries suffered from problems caused bycurrency mismatches between their external assets and liabilities,particularly by borrowing large amounts of short-term debt denominated in

10 Highlightsforeign currency. Asian economies faced similar problems during theAsian financial crisis of 1997–98.Major Latin American and Asian economies have withstood the globalfinancial crisis reasonably well as a consequence of having substantiallyreduced their foreign currency borrowing. By contrast, the debt-financedgrowth of many Eastern European economies, especially that using foreigncurrency debt, left them highly vulnerable to the latest crisis. Maintaining acautious approach to foreign currency-denominated borrowing improvessafety, but this approach has to be balanced against the benefits to financialfirms and their corporations from borrowing abroad. A sensible regulatoryapproach can be used to balance the benefits of foreign currencydenominated debt against the attendant currency risk, with one aspect ofthis being careful monitoring of the level of currency risk to which thefinancial system as a whole is exposed.Another key constraint in emerging economies is inadequateregulatory capacity that is unable to keep up with fast-evolving marketsand products. This constraint is exacerbated by the challenge thatcompetent and knowledgeable staff in regulatory bodies in theseeconomies tend to be quickly absorbed by the private sector. A revolvingdoor between regulatory bodies and the private sector can heighten the riskof regulatory capture. This is one area where multilateral institutions canplay a useful role. They can help build capacity by providing training tocountry officials, synthesizing and transferring information aboutinternational best practices, and providing direct guidance in theformulation of codes and regulations.The issue of regulatory capacity is of course closely related to theregulatory structure itself. Although there are benefits in terms ofpreventing gaps and regulatory arbitrage, establishing a single regulatormay be a significant challenge for emerging economies. In the presence ofmultiple regulatory agencies, a viable approach would be to create anoversight body that effectively coordinates the work of individualregulators, conducts macroprudential supervision, limits the degree ofregulatory arbitrage, prevents large gaps of coverage from opening up inthe regulatory framework, and oversees the regulation of largesystemically important institutions with cross-border operations. This

Financial Market Regulation and Reforms in Emerging Markets 11framework will have to be regularly recalibrated as financial marketsdevelop and become more complex.The regulatory reform agenda in emerging economies is in fact closelytied to their financial development agenda. Financial instability in some ofthese economies is caused less by unfettered innovation than byincomplete and underdeveloped financial markets. This dynamic creates itsown set of regulatory challenges, but it is worth turning directly to therelationship between two main priorities—financial development andfinancial inclusion—and see how they tie in with regulatory issues.Financial Development in Emerging MarketsThe financial crisis makes it imperative to refine rather than retreat fromthe objectives and avenues of financial development. Mobilizing savingsand effectively channeling them into productive investment remains a keychallenge for financial systems in emerging markets. In economies likeChina and India that have high private saving rates, effective financialintermediation is a key not just for promoting growth but also forimproving the welfare impact of that growth.The financial crisis is likely to shift the emphasis of the financialdevelopment agenda toward the basics of strengthening banking systems,developing basic derivatives markets such as currency derivatives, andincreasing the depth and liquidity of government and corporate bondmarkets. The papers in this section attempt to redefine the objectives andavenues of financial development in light of recent events.In major Asian emerging economies, the financial systems remainlargely bank dominated. Moreover, public sector banks (PSBs) still play adominant role in several key Asian emerging markets including China and,to a lesser extent, India. Improving the efficiency and governance of bothpublic and private banks is a key priority. However, in both of these keyAsian emerging markets as well as in many others, PSBs are often seen asinstruments of social policy, whose obligations include directing credittoward favored industries.

12 HighlightsInterestingly, the financial crisis has cast PSBs in a different light.During periods of extreme financial stress when the rest of the financialsystem freezes, public banks can serve a useful function by continuing toprovide credit as they have direct government backing. But reforms arestill necessary to incentivize these banks to turn in an adequateperformance in normal times as well. There are large but often hiddenefficiency and welfare cost

The global financial crisis has generated momentum for policymakers to craft 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 many emerging markets and low-income developing economies, even though