Current Challenges in Financial Regulation for

Emerging Markets

Keynote speech at the

2nd EMG Conference“Emerging 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 markets

Private Credit and GDP per capita growth

Finance and Volatility

Finance and Povertye(

Gro

wth

in H

eadc

ount

| X

)

Residuals Fitted Values

e(Private Credit | X)

Finance and Inequality

Residuals Fitted Values

e(Private Credit | X)

e(G

row

th in

Gin

i Coe

ffici

ent |

X)

2. Drivers of financial sector development: knowledge to date

Financial development depends on:

A. Macro-economic and fiscal stability

B. Real sector

C. Legal and judicial system

D. Proper regulation and supervision

E. Access to credible information

F. 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 reform

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

Private Credit and Creditor Rights

Stock Market and Shareholder rights

Private Credit and Contract Enforcement

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

What Works Best for Banks?

Rethinking Bank Regulation: Till Angels Govern, Rethinking Bank Regulation: Till Angels Govern, James Barth, James Barth, Gerard Caprio and Ross Levine, Cambridge University Press, 2006Gerard 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 II’s 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

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

H-Statistic (Pooled OLS)

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

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

High Interest Rate as an Obstacle

0

10

20

30

40

50

60

70

80

Small Medium Large

20th %ile

50th %ile

80th %ile

Access to Long Term Loans as an Obstacle

0

10

20

30

40

50

60

Small Medium Large

20th %ile

50th %ile

80th %ile

Yet countries vary greatly in openness (WTO Commitments Index Value)(WTO Commitments Index Value)

59

42

3432 30 30

20 20 2015 15

10 10 10 105

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0Index - lower values indicate more openness

n/a n/a n/a

Stock markets and banks complement each other in growth and development

0

1

2

3

4

Illiquid Liquid

Initial stock market liquidity

Per capita growth,1976-93

Low bankingdevelopment

High bankingdevelopment

Source: Demirgüç-Kunt and Levine, 1996.

3. Current challenges in finance

A. Triggers and changes

B. Overall approach

C. Changing special nature of banks

D. Competition policy

E. Consumer protection

F. Costs of regulation

G. 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 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

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

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

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

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

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 PillarsThree Pillars1. Better approach to competition policy

2. Better institutional arrangements

3. 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)

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

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

– Competition—between markets, sectors, products and

regulators—key to force more effective harmonization

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

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)

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., A&A), 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

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

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

– Competition—between markets, sectors, products and regulators—key to force more effective harmonization

U.S. Regulatory Regime: Multiple, Overlapping, Inconsistent and Costly Regulation

National Bank

State BankFederal Savings

Bank

Insurance Company

Securities Broker/Deale

r

Other Financial

Companies

• Fed• OTS• SEC

• 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 for

some products

Financial Holding Company

• OCC• Host County

Regulator

• Fed• Host County

Regulator

• OTS• Host County

Regulator

Federal Branch

Foreign Branch

Limited Foreign Branch

Umbrella or ConsolidatedRegulator

Primary/SecondaryFunctionalRegulator

KeyCFTC – 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

“Dual Banking”

• Ultimate decider of banking, securities, and insurance products

• Assesses effects of mergers and acquisitions on

competition

Justice Department Federal Courts

4. Issues facing emerging markets

A. International financial integrationa) Stability and volatility

b) Cross-border activities

c) Access concerns

B. Development strategiesa) Application of international standards

b) Adaptation of international standards

C. Corporate governance

D. Political economy

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)

The many links between capital flows and domestic cycles

Banking sector:initial conditions andregulatory framework

Macroeconomicconditions and policy

response

Lending boom

Macroeconomic vulnerabilityincreases while banks portfoliosbecome riskier

Investment boom

Consumption boom

Asset price increases

Collateral

Increase in short-termdebt and foreignexchange exposure

Capital Inflows

Economic Reform and Financial Liberalization

Credit Channel

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

Foreign Ownership of Banks Varies GreatlyForeign Ownership of Banks Varies Greatly

80

56 54

40

3026

2016 15

119 8 7 7 7 6

2

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n/a n/a

c) Access concerns

Starting point: Access vs. Use

Population

Users of formal financial services

Non-users of formal financial

services

Voluntary self-exclusion

Involuntary exclusion

No need

Cultural/religious reasons not to use/indirect access

Insufficient income/high risk

Discrimination

Contractual/Informational framework

Price/Product features

Access to financial services

No access to financial services

Use of finance around the world varies greatly

Financial use relates to financial depth, but is not the same

Switzerland

.

United States

Colombia Estonia Lithuania

0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0

Private Credit / GDP

0 20 40 60 80 100 % of Households Using Financial Services

SMEs complain the most

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- 0 . 0 6

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Most access barriers vary as expected with country characteristics

 Access Barriers-

DepositsAccess 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, 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?

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

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

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’

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

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

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

1 2 3 4 5 6

Equity Rights

Med

ian

Vot

ing

Prem

ium

Excludes Brazil

Better corporate governance translates into somewhat higher returns on assets

0

1

2

3

4

5

6

7

8

1 2 3 4 5 6

Equity Rights

Ret

urn

on A

sset

s

Excludes Mexico and Venezuela

But much better higher returns on investment relative to cost of capital

0.5

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0.7

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0.9

1

1.1

1 2 3 4 5 6

Equity Rights

Ret

urn

on I

nves

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t rel

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e to

C

osts

of C

apita

l

Enforcement dominates laws-on-the-books

y = 0.0457x + 1.9126

R2 = 0.0037

y = 0.9366x - 4.1358

R2 = 0.3179

0

1

2

3

4

5

6

7

8

9

10

8 9 10 11 12 13 14 15 16

log of GDP per capita

Ru

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3

3.5

4

4.5

5

An

tid

ire

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r R

igh

ts

Rule of Law Antidirector Rights Linear (Antidirector Rights) Linear (Rule of Law)

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

Private enforcement and market capitalization

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

0 0.2 0.4 0.6 0.8 1 1.2

Private enforcement index

Sto

ck

ma

rket

ca

pit

aliz

atio

n

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. 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

Ownership concentration and institutional development

Philippines

Thailand

Taiwan

Malaysia

Indonesia

Korea

Hong KongSingapore

Japan

0

2.5

5

7.5

10

0 10

203040506070Ownership by top 15 families (%)

Efficiency of judicial systemRule of law Absence of corruption

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 int’nal forums/policy making