Current Challenges in Financial Regulation for Emerging Markets Keynote speech at the 2nd EMG Confer

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Current Challenges in Financial Regulation for
Emerging Markets Keynote speech at the
2nd EMG ConferenceEmerging Markets
Finance May 15-16, 2008 , London

• By Stijn Claessens
• Professor of International Finance Policy,
  University of Amsterdam
• Assistant Director, Research Department,
• Financial Studies Division, International
  Monetary Fund

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Structure of Speech

• Importance of financial sector development
• Drivers of financial sector development
• Current challenges in finance regulation
• Issues facing emerging markets
• Conclusions

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1. Importance of financial sector development

• Finance operates through multiple channels
• Pooling resources, subdividing shares
• Transferring resources across time and space
• Managing risk
• Generating and providing information
• Dealing with incentive problems
• Resolving competing claims on wealth generated
• Empirically, finance shown to matter for
• Growth, Volatility, Poverty, Inequality, etc.
• Entry channel especially important in emerging
  markets

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Private Credit and GDP per capita growth
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Finance and Volatility
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Finance and Poverty
e(Growth in Headcount X)
e(Private Credit X)
Residuals Fitted Values
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Finance and Inequality
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2. Drivers of financial sector development
knowledge to date

• Financial development depends on
• Macro-economic and fiscal stability
• Real sector
• Legal and judicial system
• Proper regulation and supervision
• Access to credible information
• Competitive contestable markets

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A. Macro-economic, fiscal stability

• Stable macro-economic environment
• Moderate, positive real interest rates
• Appropriate exchange rate regime
• Stable fiscal environment
• Low fiscal deficits to avoid crowding out
• Limited direct role of the government in
  financial intermediation
• Low financial sector taxation

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Private Credit and Inflation
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B. Real sector

• Finance input for real sector and vice-versa
• Vicious and virtuous relationships
• Development and effectiveness of financial and
  real sector depend on many similar factors
• Yet still separate finance reform agenda
• Additional positive effect of finance on growth
• Financial sector represent allocation of control
  rights, link to general political economy of
  reform

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C. Legal and judicial system

• Good property rights, laws
• Effective legal system very important for
  financial markets, financial intermediation
• How equity and creditor rights affect financial
  development, external financing, dividend
  patterns, growth, firm valuation, etc. is well
  documented
• Includes a well-functioning judicial system that
  enforce these rights

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Private Credit and Creditor Rights
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Stock Market and Shareholder rights
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Private Credit and Contract Enforcement
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D. Regulation and supervision

• Regulation and supervision of intermediaries,
  markets
• Financial sector is highly regulation dependent
• Regulation differs from supervision. Regulation
  needs to balance market discipline and government
  supervision
• Without checks and balances, too much power in
  the hand of supervisors/regulators retards
  financial development and creates risks

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What Works Best for Banks?Rethinking Bank
Regulation Till Angels Govern, James Barth,
Gerard Caprio and Ross Levine, Cambridge
University Press, 2006

• Given typical institutional and political
  environment
• Avoid relying only on official oversight,
  restrictions etc.
• Emphasize private monitoring / incentives
• Stress Basel IIs third pillar (not capital /
  official oversight)
• Increases in deposit insurance generosity
  increase moral hazard and thereby increase
  fragility
• Supervisors have crucial role
• Support market discipline, not supplant it
• Foster / force information disclosure

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E. Access to credible information

• Information is essential for risk management,
  access to finance, efficiency of intermediation
• Information to be available on borrowers,
  consumers and financial intermediaries
• Quality of accounting auditing, rating
  agencies, credit bureaus, key components of
  informational infrastructure
• Information infrastructure has to be contestable

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Better creditor information sharing increases
private credit and eases external financing
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F. Competitive contestable markets

• Contestability of financial system key
• Contestability matters more than market structure
• State-owned institutions hinder
• Entry (including foreign institutions) helps
  stability, efficiency, access
• Structure (bank versus markets) matters less than
  having right fundamentals and open systems
• Banks complement securities markets--in
  financing, corporate governance--and vice-versa
• Most financing depends on similar determinants
• Balanced development can, however, provide a
  spare wheel

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Competitiveness depends more on contestability
than market structure
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Lower private credit with higher share of
government-owned banks
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Firms are less likely to rate high interest rates
and access to long-term loans as major obstacles
with more foreign banks
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Yet countries vary greatly in openness (WTO
Commitments Index Value)
n/a n/a n/a
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Stock markets and banks complement each other in
growth and development
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3. Current challenges in finance

• Triggers and changes
• Overall approach
• Changing special nature of banks
• Competition policy
• Consumer protection
• Costs of regulation
• Harmonization

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A. Triggers and changes

• Financial services are changing rapidly
• Deregulation within markets and products, across
  markets, geographic, including cross-border
• Technology advances in information, particularly
  internet and increased remote delivery
• Factors are changing financial services
  industries structures and altering forms of
  provision
• Banks and finance becoming less special
  increasingly more substitutes available more
  remote delivery possible local markets less
  relevant lines between products and financial
  institutions blurring
• Globalization accelerating increased (gross)
  capital flows, cross-border financial services,
  foreign bank entry, listing in financial centers

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Changing real world has implications also for
financial intermediation

• Nature of the firm altering
• Intangibles, new economy, network-type assets
  more important for production and productivity
• Investments to be financed changing
• Investors invest in ideas, rather than fixed
  assets
• Ideas need more protection for investors
• Yet often not suited for organized/formal markets
• Implications for financial sector
• Fewer fixed assets makes debt more difficult
• Higher risk requires other financing structures
• Greater importance of corporate governance
• More VC-type, more equity markets for VC to exit

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B. Overall approach

• Overall approach reaffirming fundamentals
• New evidence confirms crucial role of
  fundamentals
• Yet need to revisit continuously fundamentals
• Greater emphasis on enabling environment
• Property rights, information infrastructure, etc.
• Reduced, but more focused role of government
• Do not expect government to solve all problems
• But neither will market always
• Focus on core role of government, with some
  market-friendly interventions

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C. Special nature of banks

• Greater substitutes for bank liquidity available
• Reducing specialness of banks
• New roles for banks and increased conglomerates
• More risk managers, as within financial
  conglomerates
• Introducing new risks and oversight challenges,
  e.g., LCFI
• Revisit prudential and institutional-oriented
  approaches
• Revisit tools/approaches used for managing risks
  ? Basel II
• Higher transparency, better corporate governance
  ? Pillar III ?
• Protect more core elements (payments system)
  against spillovers
• Less cylinder approaches, stress more common
  elements
• Reduced special nature of banks implies less need
  for public safety net and requires adjustment of
  standards

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D. Competition policy

• Competition is important in the financial sector
• As in other sectors, competition affects
  efficiency, costs and incentives of institutions
  markets to innovate
• Competition in finance, however, is complex,
  w/tradeoffs
• Access to credit depends on franchise value, but
  degree of competition can negatively/positively
  affect access
• Too much competition can undermine stability ?
  crises
• Structure matters, but in complex ways, e.g.,
  effects of entry/exit rules, economies of
  scale/scope, networks, etc.
• Financial services industries are continuously
  changing

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Competitive landscape is changing
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More and better competition policy both possible
and needed

• Finance and banks particularly less special
• Global and across types of services/institutions
• The (new) competition policy paradigm to
  involve Three Pillars
• Better approach to competition policy
• Better institutional arrangements
• Better (new) tools to be used
• Ultimate goal (new?) paradigm
• Competition policy to be functional, global
• To resemble other network industries (e.g.,
  telecommunications, energy)

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Approaches

• Competition policy to combine three approaches
• Institutional assure contestable markets by
  proper entry/exit of institutions, domestic and
  cross-border
• Functional assure contestable markets by
  leveling playing field (in all dimensions) across
  similar financial products services
• Production assure efficiently provided, equal
  accessible, affordable network services
  (information, distribution, settlement, clearing,
  payment, etc.)
• So far Institutional Big barriers have been
  removed, but many small remain. Functional long
  way to go Production less discussed so far

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More gains to be gotten from institutional and
functional approach

• Further liberalize/harmonize across markets,
  sectors, products, by functions so
  locations/labels not matter
• Complex, since
• Costs of regulation hard to assign to specific
  functions, products, e.g., payments services
• Path dependency, e.g., tax differences in savings
  products
• Subtle distortions/benefits, e.g., safety net,
  LoLR
• Policy responses
• More integrated/single supervisors may or may not
  help
• Global standards can help, but still country
  differentiation
• Competitionbetween markets, sectors, products
  and regulatorskey to force more effective
  harmonization

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Institutional arrangements

• Competition policy to be given more weight
• Competition policy to be (more) separate from
  supervision
• Effective competition authority with good
  enforcement
• Competition policy to be more harmonized
• Horizontal and vertical across various financial
  services
• For specific inputs/links, including other,
  non-financial
• Competition policy to be more coordinated
• Integrate with overall information/technology
  competition policy
• Many markets are global, but competition policy
  not yet
• Existing mechanisms can be used more WTO (all
  GATS modes), FTAs

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Tools to analyze competitiveness

• Analysis is, and will remain, difficult
• Market and product definitions will become even
  harder
• Barriers to entry complex may arise from sunk
  costs, economies of scale and scope,
  externalities
• Network effects exist in supply, demand, and
  distribution
• Tools far behind and need to be adjusted
• Borrow more from traditional IO or other
  (services), but adapt to special nature of
  financial services
• Less market structure, more conduct analysis
• More focus on access pricing and policies for key
  market infrastructures (e.g., payments systems,
  information, credit bureaus, trading systems)

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E. Consumer protection

• Assuring proper business conduct
• Long-standing issue, but recent events show that
  small distortions hurt consumers and negatively
  affect integrity
• Limit conflict of interests, increase oversight,
  especially in capital markets, of key issues
  (e.g., AA), take strong actions (e.g., NY SEC)
• Protecting individual consumers
• Can no longer assure fairness of products and
  markets
• Buyer beware to be matched by increased truth
  in advertising requirements, liability and means
  of users to take legal actions
• Assuring consumers obtain the greatest benefits
• Increased choices and complexity not (yet)
  matched by knowledge
• Requires more financial education, starting at an
  early age

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F. Costs of regulation

• Deregulation followed by reregulation now too
  much regulation and too intense oversight?
• Direct and indirect (compliance) costs have
  increased
• With possible adverse effects, e.g.,
• SOX may lead to migration of US IPOs to UK fewer
  new listed firms
• AML/CFT can affect access of households
• Markets players and governments have recognized
  this
• e.g., EU Action Plan streamline regulations, US
  competitiveness reports
• Proper policy responses
• More formal cost-benefit analysis needed
• More transparency and greater consultation to
  balance tradeoffs
• Without inviting capture, need to have broad(-er)
  representation of producers and consumers in
  processes

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G. Harmonization

• Big barriers have been removed, but many small
  remain
• Further harmonize across markets, sectors and
  products, by functions, so that labels no longer
  matter. Complex as
• Costs of regulation hard to assign to specific
  functions/products
• Path dependency, e.g., tax differences
• Subtle distortions/benefits, e.g., safety net,
  LLR
• Policy responses
• More consolidated/single supervisory authorities
  may help
• Standards help globally, but country
  differentiation unavoidable
• Better data and more transparency on prices and
  costs
• Competitionbetween markets, sectors, products
  and regulatorskey to force more effective
  harmonization

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U.S. Regulatory Regime Multiple, Overlapping,
Inconsistent and Costly Regulation
Financial Holding Company
Justice Department
Federal Courts

• Fed
• OTS
• SEC

• Ultimate decider of banking,
• securities, and insurance
• products

• Assesses effects of mergers
• and acquisitions on
• competition

Umbrella or Consolidated Regulator
Dual Banking

• OCC
• FDIC

• State BankRegulators
• FDIC and/or
• Fed

• OTS
• FDIC

• 50 State InsuranceRegulators plusDistrict of
  Columbia
• and Puerto Rico

• FINRA
• SEC
• CFTC
• State Securities Regulators

• Fed
• State Licensing(if needed)
• U.S. Treasury forsome products

Primary/ Secondary Functional Regulator
Key CFTC Commodity Futures Trading
Commission FDIC Federal Deposit Insurance
Corporation Fed Federal Reserve FINRA -
Financial Industry Regulatory Authority OCC
Comptroller of the Currency OTS Office of
Thrift Supervision SEC Securities and Exchange
Commission

• OCC
• Host County Regulator

• Fed
• Host County Regulator

• OTS
• Host County Regulator

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4. Issues facing emerging markets

• International financial integration
• Stability and volatility
• Cross-border activities
• Access concerns
• Development strategies
• Application of international standards
• Adaptation of international standards
• Corporate governance
• Political economy

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A. International financial integration
a) stability and volatility

• Developing countries, emerging markets
  especially, subject to rapid financial
  integration
• Large capital flows, foreign bank entry, capital
  market migration
• Forcing adjustment faster than in current
  developed past
• Need for more rapid institutional development
• Intermediate level of (financial)
  development/openness most risky
• Integration ? more stability, but at times also
  volatility ?
• Greater emphasis on measurement and management of
  risks
• May need to keep toolkit to intervene (e.g.,
  capital account controls, circuit brakers,
  tighter restrictions)

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The many links between capital flows and domestic
cycles
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b) Cross-border activities

• Increased foreign bank presence, foreign capital
  markets activities on- and offshore, raising
  specific questions
• Costs of regulation and supervision increase with
  (multiple) coordination with home countries
• Yet capacity of emerging markets lower and
  effects of banking failure and financial crisis
  higher
• Foreign investors/financial institutions not
  internalize all issues
• Lack of paradigm more costly for emerging markets
  
• Rule for cross-border bank resolution, capital
  markets oversight ambiguous in some respects
• Inefficient responses, e.g. subsidiaries, create
  additional costs/risks

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Foreign Ownership of Banks Varies Greatly
n/a n/a
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Access concerns Starting point Access vs. Use
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Use of finance around the world varies greatly
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Financial use relates to financial depth, but is
not the same
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SMEs complain the most
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Most access barriers vary as expected with
country characteristics
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Access concerns

• Large foreign bank entry ? more access generally,
  but
• Access to information-intensive firms may suffer
  when hard-information banks come in
• Local information production when foreign banks
  list abroad, less information, less market
  discipline, more complex monetary policy
• Large migration in capital markets ? benefits
  but
• While larger firms gain, local liquidity can
  decline, making it harder for other (small) firms
  to raise financing locally
• Local capital markets activities in general
  decline as business is reduced, hindering
  development
• Policy responses
• Specific corporate governance and listing
  requirements for local subsidiaries?
• More harmonization and more specialization in
  capital markets?

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B. Development strategies

• Countries have less freedom to pursue own
  approaches
• Good on one hand, since state has mostly not been
  productive
• Yet many now successful economies have had some
  interventions
• Countries can combine, but only to some extent
• Can benefit from committing through international
  agreements
• While pursuing some national objectives, through
  lending requirements, development financial
  institutions, etc.
• Balance can be precarious deter entry, raise
  costs, distort

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a. Application of international standards

• Standards (Core 25, Basle II, IOSCO, etc) help,
  but
• Many not applicable, too sophisticated and
  sometimes even wrong given issues facing
  developing countries
• Markets missing, capacity to implement lacking,
  enforcement, etc
• Special nature of banks and safety net can be
  perverse
• Many country-specific requirements and tradeoffs
• E.g., degree of competition and access to
  financing relate differently when information
  more obscure. Size of market matters
• Yet signal of poor compliance a problem.
  Implications
• Regulations to be applied to vary. Focus on key,
  priority elements regulatory governance,
  corporate governance, transparency
• Consider multiple enforcement approaches, not
  just public

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b. Adaptation of international standards

• Adapt standards and assessment over time
• Standards to be adapted to changing world and
  lessons learned
• Need to consider assessor/methodologies
  consistencies
• Need to include all relevant parties in review
• Increase stake of emerging markets in
  international standard setting forums (BCBS,
  CPSS, etc.) and IFIs (IMF, WB)
• Consider legitimacy, which may mean raising
  stakes even more
• Provide technical assistance in negotiations in
  FTAs, GATS, etc to level playing field
• Balance private sector/producers interests with
  consumers

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c. Specific competition (policy) issues for
emerging markets

• Competition policy especially complex
• Often small systems. Many links between finance,
  corporate sector, government, political economy.
  Limited data to measure
• Hard to develop a credible competition agency.
  Compromise, e.g., inside instead of outside
  supervisory agency, can be costly
• Commitment to pro-competition more beneficial
• Since competition policy authorities weaker,
  political economy more adverse and credibility at
  a premium, external can help
• International agreements (WTO, FTAs) can
  commit/enforce
• Active role of government can be needed given
  externalities and coordination issues, e.g.,
  payments system

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C. Corporate and regulatory governance

• Deeper challenges for development
• Corporate governance can be elusive
• Better protection of investors
• Better governance inside firms
• Better incentives to accumulate human capital
• Regulatory governance and enforcement
• Crucial to development.
• North (1991) single most important determinant
  of economic performance
• Financial markets depend on legal environment,
  but incomplete without enforcement

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Weak corporate governance translates into higher
cost of capital
Excludes Brazil
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Better corporate governance translates into
somewhat higher returns on assets
Excludes Mexico and Venezuela
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But much better higher returns on investment
relative to cost of capital
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Enforcement dominates laws-on-the-books
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What enforcement mechanisms? Continuum of
alternative tools

• Private ordering
• Exception rather than norm
• Unilateral, bilateral and multilateral, with
  multilateral mechanisms especially often used in
  finance
• Private law enforcement
• Litigation most important tool
• Public law/regulation enforcement
• Traditional view of enforcement
• State-ownership/control
• Has many problems, but may be considered

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Private enforcement often works better in
securities markets
Each point represents one of 49 countries. Data
from LLS (2005).
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D. Political economy

• Finance in emerging markets same principles and
  industry undergoing similar changes as ROW.
  However
• While countries generally benefit from reform and
  lib., not clear what pre-conditions are for
  successful reform
• And some failures. Regulator/supervisor capture
  major constraint
• Government poor regulator, e.g., more power does
  harm if checks and balances missing minimally
  paid supervisors unlikely to resist corruption
  securities markets private better than public
  oversight
• Often deeper causes political economy,
  corruption, etc.
• Limits to what government/regulation can achieve.
  Rebalance role of government relative to private
  sector
• Consider quantity restrictions, to avoid risks,
  preserve incentives, but need to avoid negative
  signals

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Ownership concentration and institutional
development
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5. Conclusions

• Fundamentals confirmed
• Yet, changing emphasis and adaptation needed
• Level playing field
• More harmonization with increased competition
• Competition policy
• Often missing so far, but more needed and
  possible
• Consumer protection
• Increased emphasis, more tools and more education
• Role of standards
• Useful to a point, need to evolve, require proper
  inputs
• Emerging markets challenges
• Fast financial integration requires specific
  responses
• Better representation in intnal forums/policy
  making