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


Current Challenges in Financial Regulation for Emerging Markets Keynote speech at the 2nd EMG Conference Emerging Markets Finance May 15-16, 2008 , London – PowerPoint PPT presentation

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

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

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

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

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

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

Private Credit and Inflation
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

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
  • Includes a well-functioning judicial system that
    enforce these rights

Private Credit and Creditor Rights
Stock Market and Shareholder rights
Private Credit and Contract Enforcement
D. Regulation and supervision
  • Regulation and supervision of intermediaries,
  • Financial sector is highly regulation dependent
  • Regulation differs from supervision. Regulation
    needs to balance market discipline and government
  • Without checks and balances, too much power in
    the hand of supervisors/regulators retards
    financial development and creates risks

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
  • 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
  • Supervisors have crucial role
  • Support market discipline, not supplant it
  • Foster / force information disclosure

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

Better creditor information sharing increases
private credit and eases external financing
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

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

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
  • 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

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
  • 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

B. Overall approach
  • Overall approach reaffirming fundamentals
  • New evidence confirms crucial role of
  • 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

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
  • Introducing new risks and oversight challenges,
    e.g., LCFI
  • Revisit prudential and institutional-oriented
  • 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
  • Reduced special nature of banks implies less need
    for public safety net and requires adjustment of

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,
  • Access to credit depends on franchise value, but
    degree of competition can negatively/positively
    affect access
  • Too much competition can undermine stability ?
  • Structure matters, but in complex ways, e.g.,
    effects of entry/exit rules, economies of
    scale/scope, networks, etc.
  • Financial services industries are continuously

Competitive landscape is changing
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)

  • Competition policy to combine three approaches
  • Institutional assure contestable markets by
    proper entry/exit of institutions, domestic and
  • 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

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
  • Subtle distortions/benefits, e.g., safety net,
  • Policy responses
  • More integrated/single supervisors may or may not
  • Global standards can help, but still country
  • Competitionbetween markets, sectors, products
    and regulatorskey to force more effective

Institutional arrangements
  • Competition policy to be given more weight
  • Competition policy to be (more) separate from
  • Effective competition authority with good
  • Competition policy to be more harmonized
  • Horizontal and vertical across various financial
  • For specific inputs/links, including other,
  • 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

Tools to analyze competitiveness
  • Analysis is, and will remain, difficult
  • Market and product definitions will become even
  • Barriers to entry complex may arise from sunk
    costs, economies of scale and scope,
  • Network effects exist in supply, demand, and
  • 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)

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
  • 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

F. Costs of regulation
  • Deregulation followed by reregulation now too
    much regulation and too intense oversight?
  • Direct and indirect (compliance) costs have
  • 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
  • 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

G. Harmonization
  • Big barriers have been removed, but many small
  • 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
  • Path dependency, e.g., tax differences
  • Subtle distortions/benefits, e.g., safety net,
  • Policy responses
  • More consolidated/single supervisory authorities
    may help
  • Standards help globally, but country
    differentiation unavoidable
  • Better data and more transparency on prices and
  • Competitionbetween markets, sectors, products
    and regulatorskey to force more effective

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
  • and Puerto Rico
  • 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
  • OCC
  • Host County Regulator
  • Fed
  • Host County Regulator
  • OTS
  • Host County Regulator

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

A. International financial integration
a) stability and volatility
  • Developing countries, emerging markets
    especially, subject to rapid financial
  • 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
  • May need to keep toolkit to intervene (e.g.,
    capital account controls, circuit brakers,
    tighter restrictions)

The many links between capital flows and domestic
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
  • 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

Foreign Ownership of Banks Varies Greatly
n/a n/a
Access concerns Starting point Access vs. Use
Use of finance around the world varies greatly
Financial use relates to financial depth, but is
not the same
SMEs complain the most
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
Access concerns
  • Large foreign bank entry ? more access generally,
  • 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
  • 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
  • Policy responses
  • Specific corporate governance and listing
    requirements for local subsidiaries?
  • More harmonization and more specialization in
    capital markets?

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

a. Application of international standards
  • Standards (Core 25, Basle II, IOSCO, etc) help,
  • 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
  • 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.
  • Regulations to be applied to vary. Focus on key,
    priority elements regulatory governance,
    corporate governance, transparency
  • Consider multiple enforcement approaches, not
    just public

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
  • 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

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
  • Active role of government can be needed given
    externalities and coordination issues, e.g.,
    payments system

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

Weak corporate governance translates into higher
cost of capital
Excludes Brazil
Better corporate governance translates into
somewhat higher returns on assets
Excludes Mexico and Venezuela
But much better higher returns on investment
relative to cost of capital
Enforcement dominates laws-on-the-books
What enforcement mechanisms? Continuum of
alternative tools
  • Private ordering
  • Exception rather than norm
  • Unilateral, bilateral and multilateral, with
    multilateral mechanisms especially often used in
  • 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

Private enforcement often works better in
securities markets
Each point represents one of 49 countries. Data
from LLS (2005).
D. Political economy
  • Finance in emerging markets same principles and
    industry undergoing similar changes as ROW.
  • 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
  • Often deeper causes political economy,
    corruption, etc.
  • Limits to what government/regulation can achieve.
    Rebalance role of government relative to private
  • Consider quantity restrictions, to avoid risks,
    preserve incentives, but need to avoid negative

Ownership concentration and institutional
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
  • Consumer protection
  • Increased emphasis, more tools and more education
  • Role of standards
  • Useful to a point, need to evolve, require proper
  • Emerging markets challenges
  • Fast financial integration requires specific
  • Better representation in intnal forums/policy
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