Chapter 21 Containing The Risks of Future Crises: Strengthening the Regulatory Framework
- International Monetary Fund
- Published Date:
- January 2001
As we learned on the first day of this conference, the causes of the Asian crisis are manifold. Judging from the fact that financial systems in many of the countries involved in the crisis came to the brink of collapse or in some cases actually collapsed, I think it is fair to conclude that failing banking supervision plays a major part in explaining the crisis. The events in Asia have once again proven that exposing poorly regulated and supervised financial systems to huge global capital flows is a hazardous act.
It was precisely for this reason that last year, when I had the honor of serving as its chairman, the Basle Committee on Banking Supervision formulated, in conjunction with supervisors in emerging markets, the twenty-five “Core Principles for Effective Banking Supervision.” The principles were approved by the G-7 countries last year and are now about to be implemented in individual countries around the world, because it is believed that strengthening banking supervision worldwide can contribute to preventing calamities like we have witnessed lately in Asia and Russia.
Effective banking supervision is, in my opinion, extremely important for ensuring global financial stability. But implementing the principles of the Basle Committee can only be accomplished in an environment that actually can enforce them. For how effective is supervision if supervisors have no means to enforce their regulations in banks, or can be overruled by governments at any time? How can supervisors judge banks credit and investment policies when there is no adherence to accepted accounting principles and when private property laws are ill-defined?
So apart from the principles for banking supervision, I would also like to discuss with you today the preconditions which should be met for supervisors to be able to do their work properly. Although preconditions are mentioned in the document of the Basle Committee, they may have remained somewhat underexposed until now. In some circles, the committee was criticised for devoting too little attention to the preconditions that should be in place to successfully implement the core principles, mentioning them only in the introduction and hardly elaborating on them. In response to those criticisms, I would like to point out that supervisors in general, and the Basle Committee in particular, are not the right parties to criticise in this respect. Clearly, supervisors cannot claim the authority to prescribe the preconditions I would like to discuss with you today. Having moved to the private sector, however, I feel more at liberty to do so. I would like to end my contribution today by discussing the means we can employ to persuade governments to implement both the principles and the preconditions.
Part of the cause of the Asian crisis lies with banks and other financial institutions that were taking too much risk by funding short-term, mostly in dollars, and investing in long-term, mostly high-risk property projects, in many cases generating local currency income. Moreover, ill-managed government influence on investment decisions was rather common in most of the afflicted countries.
As supervisors were, and in many cases still are not politically independent and had little formal enforcement mechanisms, they were in a weak position to prevent government influence on the banks. Capital requirements were apparently too low, which contributed to excessive risk-taking by the management and owners of the financial institutions. Supervision of the credit process and the quality of the investment portfolio, of provisions, of the interest rate, liquidity and exchange risks of the funding and of asset and liability management was clearly failing, given the events that led up to the crisis. In many cases, the financial institutions formed part of industrial conglomerates, inducing connected lending without proper credit assessment. The absence of information systems to show those concentration risks, and the absence of limit systems, hampered the work of the supervisors. There was a lack of transparency, partly because there was no authority able to enforce it. Coordination with other supervisors was lacking. As a result, problems did not become visible until it was already too late for many corrective measures. The banking system was left with a large share in nonperforming loans, which at present squeezes further credit.
Banking supervision in Asia thus shows major shortcomings if we compare it with the Basle Committee principles. Consequently, there were no warning systems in place which would have helped the authorities to take timely action and thus possibly prevent many of today’s problems. However, it is unlikely that simply introducing the principles today would be enough to prevent financial instability in the future. Supervisors do not operate in a vacuum. As I said, certain preconditions need to be in place for supervision to be able to function properly.
In the “Core Principles for Effective Banking Supervision,” five preconditions are said to be essential for properly functioning banking supervision. They are:
- 1. Sound and sustainable macroeconomic policies;
- 2. A well-developed public infrastructure;
- 3. Effective market discipline;
- 4. Procedures for efficient resolution of problems at banks; and
- 5. Mechanisms for providing an appropriate level of systemic protection (or public safety net).
What is meant by each of these five points and how do they relate to what happened in Asia?
- 1. If macroeconomic policies are such that they undermine the stability of the financial system, banking supervisors are faced with a virtually impossible task. Is economic policy to blame for the Asian crisis? With hindsight, it is not too difficult to put the finger on some sore points. In all crisis-hit countries, pegging the currency to the dollar was part of the economic policy. Although banking supervision was insufficient, capital flows were liberalised. There was no supervision of foreign capital inflows, especially short-term capital. The fixed peg to the dollar required high domestic interest rates, so that companies turned abroad for their funding. Supervisors did not put caps on open currency positions of banks and other financial institutions, or did so only to a limited extent. The fixed dollar exchange rate made them believe that the currency risk was small, so they didn’t bother to hedge their positions.
This was, of course, a gross miscalculation. When the dollar appreciated strongly against both the European currencies and the Japanese yen, while the Japanese economy grew weaker and weaker, the Asian countries were confronted with an erosion of their competitiveness and a deterioration of their current accounts. The peg to the dollar had to be abandoned; the devaluation that followed caused massive financial problems and a reversion of short capital streams.
These macroeconomic events are another part of the explanation of the Asian crisis, but there are more, quite fundamental factors that lay at the root of things. These will be addressed in the review of the rest of the preconditions.
- 2. Under the heading of a well-developed public infrastructure, we combine things like a well-developed legal system and the existence of, and adherence to well-defined accounting rules. The latter should be ensured by independent auditors, declaring that financial statements give a fair view of the financial situation of companies. There should be effective supervision of banking (as described by the principles) and of other financial markets, and there should be a secure and efficient payment and clearing system for the settlement of financial transactions. If these facilities are not provided for, legal security is undermined, which can easily lead to destabilisation of financial systems.
- In many Asian countries, accounting principles hardly comply with internationally accepted standards, which greatly complicates the risk assessment of an investment. There are no serious penalties for publishing inaccurate information. We also find ample examples of deficiencies in the legal system, such as the absence of well defined private property laws, bankruptcy laws, standard contracts, and the possibility of seizing collateral.
Financial markets are another part of the public infrastructure. They are mostly underdeveloped in the Asian countries, as pension funds, insurance companies, and mortgage banks only play a minor role. The funding of the economic process relies on debt rather than equity. The stability of foreign funding could also be helped by the existence of well-functioning domestic capital markets. It would encourage foreign capital to take the form of more stable equity and bond investments rather than volatile short-term, foreign currency bank lending.
- 3. Effective market discipline requires that sufficient, transparent, and reliable information is available for all market participants. In Asia, there was a clear lack of information that would enable depositors and supervisors to judge the financial health of banks. The fact that long-term property investments were funded with short dollar liabilities, for example, was not visible to outsiders. The lack of information thus led to an unintentional increase in high-risk investments. Conversely, a lack of information can lead to a run on banks when the public for some reason loses faith in the financial system, even if the panic is just based on rumors and the banks in question are basically sound.
A properly functioning market mechanism should also prevent investors and bank managers from being safeguarded against the negative consequences of their decisions. The conviction that the government would bail them out in the case of large losses led financial institutions in Asia to take excessive risks, which lay at the root of the financial crisis.
Governments influencing commercial decisions—whether to support government policy or to favor certain groups—also led to wrong investment decisions and increased the problems in the Asian financial sector. The same goes for relations between financial institutions and companies that are far too close. The chaebols in South Korea, the finance companies in Thailand and government-linked banks in Indonesia are all examples of institutions that make decisions on the basis of relationships or government influence, rather than on sound commercial considerations. China, which also has a massive banking problem but has been able to skirt around the edges of the storm until now, is another distinct example in this respect. (The problem is closely related to the political system and therefore requires wide-ranging reforms.)
- 4. The prompt and orderly exit of institutions that are no longer able to meet supervisory requirements is a necessary part of an efficient financial system. Muddling through often makes things worse.
- 5. Putting into place a public safety net or deposit insurance system can induce people to keep their savings with banks. It stabilizes the financial system by preventing negative developments at one bank from contaminating other, possibly healthy institutions. However, such guarantees always bear the risk of distorting market signals. This distortion works both ways. Bank managers’ appetite for risk tends to increase if they perceive that they are implicitly backed by government guarantees. The Thai finance companies, government-linked banks in Indonesia and chaebol-controlled banks in South Korea, but also the saving and loan companies in the U.S. are clear examples. On the other hand, a comprehensive safety net reassures bank depositors and reduces the need to assess the safety of the banks with which they deposit their money.
To prevent distortion of market signals as far as possible, the system should insure depositors only to a maximum percentage, so that they still bear some risk of their own, and/or a maximum amount, so that only small depositors are fully protected. The risk appetite of banks can be limited by leaving the responsibility of a guarantee system with the banks through a contribution system, with no recourse on government funds.
We have now looked at the preconditions, which should ensure an environment in which banking supervision can function effectively. Implementing these in the countries that are presently struggling to overcome financial instability will prove to be a hard and lengthy process, because we are talking about true political and social reforms. And these may not even be sufficient. What if laws are well formulated and recorded, but the courts are corrupt? Then there will still be legal insecurity.
We may therefore need to formulate more fundamental conditions if these preconditions are to be effective and financial systems to be stable in the long run. A stable government is essential for sound and sustainable macroeconomic policies. Indicators like the (in) equality of income distribution, the “tolerance level” in a society (for example with respect to religion), standards of health care and education and the existence of an effective social security system are probably factors which influence stability in the longer run. A true division of powers and independent judges are prerequisites for legal security and the fair settlement of disputes.
In spite of the fact that the Asian countries showed many deficiencies in these respects, foreign investors were more than willing to invest their money and profit from the high growth rates that were so common in these countries for many years. Yet, one of the lessons we may have to learn from the Asian crisis and present conditions in Russia is that the risks of investing in a country that fails to put the basic conditions for stability in order are higher than we were recently inclined to think.
The countries in Asia that are troubled by the crisis are developing various measures to deal with financial instability, mostly in conjunction with the IMF. There is one element of short-term crisis management I would like to discuss with you in some more detail, which is the establishment of capital controls. In this connection, it should be recognized that in many countries, many de facto forms of capital control are already in place through the system of supervisory regulation. Limits on foreign exchange exposures, or regulations that limit the admission of foreign banks, are examples of supervisory measures that also have the effect of capital control. Nevertheless, the tightening of capital controls recently announced in Malaysia runs (somewhat) counter to existing trends.
The liberalization of capital streams offers some distinct advantages above maintaining restrictions. More funds will flow into the country and the pricing will be relatively low (as investors can fairly easily withdraw). Moreover, a liberalized capital market is usually judged to be a positive point in the general assessment of countries.
As a result of capital controls, the influx of foreign capital is very likely to dry up. As in the longer term, countries will want to attract foreign capital again; capital controls can only be a short-term solution. We are probably talking about months rather than years. And even if they are maintained only for a short period of time, investors may remain reluctant to re-enter the market for a prolonged period.
Therefore, capital controls should only be used as a means to restore calm, in order to support the currency and reestablish stability. In order to be effective, they should be accompanied by complementary measures aimed at putting more fundamental matters in order. Apart from that, capital controls can only be useful under certain conditions. In the first place, the economy to which they are applied should be reasonably small for the restrictions to be sustainable. Second, public infrastructure should be developed enough to allow for proper checks on compliance with the directives. In the present situation Russia, for example, could never effectively introduce capital controls because it would be impossible to arrange adequate surveillance of compliance.
However, one can question whether it was wise to expose the underdeveloped banking systems in the Asian countries to the rapid exchange liberalization of the sophisticated financial markets in the developed countries.
Clearly we should recognize that neither the preconditions nor the supervisory systems were in place to set the stage for balanced and healthy development of the financial systems in the Asian countries over the last decade.
Fixing the problems in Asia and safeguarding international financial stability in the longer term requires wide-ranging legal, infrastructural and educational changes. How do we bring them about?
First and foremost this is the responsibility of the countries in question. No external force, be it the market or the IMF, can enforce change without the political will and very substantial efforts of the Asian countries themselves. In this respect, it is encouraging that a country like Indonesia is now making serious efforts to change its banking and bankruptcy laws. Less encouraging are the very slow developments in Korea, where the intended efficiency measures to be taken by the chaebols so far seem to have yielded little progress.
The markets can play a beneficial role. Risks should translate more directly and effectively into spreads. For example, spreads over Libor of the bonds of the ABN AMRO Bank “Global Limited Recourse Debt Issuance Program” show that in September 1997, the Indonesian country risk was priced in the capital market at no more than sixty basis points over US Treasury. When troubles began last year, the spread rose gradually to some 110 bp. However, when the full extent of the crisis became visible, the spread rose to 1,400 bp by mid-October, at least clearly showing that risks had been seriously underestimated before. Another part of the market mechanism is the role of the rating agencies. Unfortunately we have to recognize that their original reaction to the crises did not alleviate the problems. The rating agencies continue to improve their ability to assess country risks, increasing the weighting of conditions that determine financial stability in the ratings.
Foreign supervisors can put “peer pressure” on their colleagues that have less well-developed supervisory systems. Pressure on supervisors could also come from foreign banks that have to compete with domestic banks subject to less strict supervision. One could even argue that banking supervision in emerging markets should in fact be stricter than in industrialized countries. Emerging markets are more volatile and therefore riskier, and banking problems often have a larger negative impact upon emerging economies, because there is no developed capital market.
The IMF, and other international financial institutions, can and have made their loans conditional on the implementation of reforms. However, in an acute crisis situation the IMF, too, will prefer reestablishing short-term stability over demanding long-term political reforms. We must also, in view of past experience, question the likelihood of international consensus on action to be taken against countries that fail to implement reforms. This may therefore be a long and not very efficient way of realising the objective of financial stability.
Finally, markets should be aware of the fact that if fundamentals are wrong in a country, sooner or later the bomb may explode, and markets should act on that knowledge, thus forcing countries to act.
As Jerry Corrigan recently said in a speech “It is virtually impossible for a country to escape from a financial crises without incurring a substantial decline in economic activity. Like it or not, that is the reality.
Given the hardships that such a substantial decline entails, it is vital that public and private institutions cooperate with the countries in question to help them to set their houses in order.