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

1
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

2
Structure of Speech

1. Importance of financial sector development
2. Drivers of financial sector development
3. Current challenges in finance regulation
4. Issues facing emerging markets
5. Conclusions

3
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

4
Private Credit and GDP per capita growth
5
Finance and Volatility
6
Finance and Poverty
e(Growth in Headcount X)
e(Private Credit X)
Residuals Fitted Values
7
Finance and Inequality
8
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

9
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

10
Private Credit and Inflation
11
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

12
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

13
Private Credit and Creditor Rights
14
Stock Market and Shareholder rights
15
Private Credit and Contract Enforcement
16
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

17
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

18
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

19
Better creditor information sharing increases
private credit and eases external financing
20
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

21
Competitiveness depends more on contestability
than market structure
22
Lower private credit with higher share of
government-owned banks
23
Firms are less likely to rate high interest rates
and access to long-term loans as major obstacles
with more foreign banks
24
Yet countries vary greatly in openness (WTO
Commitments Index Value)
n/a n/a n/a
25
Stock markets and banks complement each other in
growth and development
26
3. Current challenges in finance

1. Triggers and changes
2. Overall approach
3. Changing special nature of banks
4. Competition policy
5. Consumer protection
6. Costs of regulation
7. Harmonization

27
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

28
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

29
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

30
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

31
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

32
Competitive landscape is changing
33
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)

34
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

35
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

36
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

37
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)

38
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

39
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

40
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

41
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
National Bank State Bank Federal Savings Bank Insurance Company Securities Broker/Dealer Other Financial Companies

• 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
Federal Branch Foreign Branch Limited Foreign Branch
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

42
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

43
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)

44
The many links between capital flows and domestic
cycles
45
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

46
Foreign Ownership of Banks Varies Greatly
n/a n/a
47
Access concerns Starting point Access vs. Use
48
Use of finance around the world varies greatly
49
Financial use relates to financial depth, but is
not the same
50
SMEs complain the most
51
Most access barriers vary as expected with
country characteristics
  Access Barriers-Deposits Access Barriers-Loans
Banking Freedoms - 0.563 -0.474
Media freedom - 0.327 -0.425
Credit information index -0.302 -0.275
Official supervisory power 0.231 0.071
Market-based supervision -0.1 -0.374
Physical infrastructure failures 0.264 0.209
Government bank share -0.002 0.004
Foreign bank share -0.005 -0.001
Creditor rights -0.06 0.03
52
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?

53
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

54
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

55
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

56
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

57
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

58
Weak corporate governance translates into higher
cost of capital
Excludes Brazil
59
Better corporate governance translates into
somewhat higher returns on assets
Excludes Mexico and Venezuela
60
But much better higher returns on investment
relative to cost of capital
61
Enforcement dominates laws-on-the-books
62
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

63
Private enforcement often works better in
securities markets
Each point represents one of 49 countries. Data
from LLS (2005).
64
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

65
Ownership concentration and institutional
development
66
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