Financial Stability in Emerging Market Economies

Mr Timothy Geithner, Mr Chairman, Ladies and Gentlemen,

1. I am delighted to join this Symposium and speak in the same session with my good friend Gavin Bingham. The purpose of this session is to present some thoughts on financial stability issues in the light of growing capital flows. This is clearly an issue of the highest priority, given what has been happening in the Southeast Asian financial markets in recent months as a result of the Thai crisis.
2. My presentation this morning will be divided into two parts. First, I will reiterate some points that I made recently in Kuala Lumpur. These basically relate to the fact that although financial markets are global, financial regulations, laws and all the stresses and strains in terms of global capital flows are all local in nature, so that the domestic banks bear the brunt of adjustment. This is clearly the lessons from the recent experience in Asia.
3. The second part of my presentation will focus on implementation issues relating to financial regulation. Thanks to Gavin who has just given us an excellent and comprehensive overview of the Report of the Working Party on Financial Stability in Emerging Market Economies, I have a good background to build upon. Specifically, I shall highlight four key areas:-
   • First, the approaches to financial regulation can be summarised along four major lines: internal governance, official oversight, market discipline and robust financial infrastructure. Internal management largely complements external supervision and regulation. The practical means to improve stakeholders oversight is through the right incentive structure and market discipline. Despite all its faults, the market does work, and the trick is how to make the market work better. Financial stability, especially in emerging economies, depends not on regulatory approaches that avoid risks or cap risks at the expense of the state, which in economic terms means moral hazard. It is more important to ensure that the market manages the risks more efficiently. Modern supervisory approaches strongly involve greater market transparency, so that not only do financial institutions manage their own risks better, the market peer pressure will enforce regulatory discipline on behalf of the regulator.
   • Second, on addressing financial regulatory issues, we see no shortage of initiatives. The Report of the Working Party on Financial Stability in Emerging Market Economies and the Basle Committee's Core Principles provide an excellent roadmap for global financial stability. However, the question still remains one of implementation. What early warning signals are there to prevent crises? How do we avoid bureaucratic inertia that may ignore these warning signals or delay the necessary cures? These problems cannot be solved at the international level, but must be addressed at the national level. Perhaps we should ask what incentives or disincentives exist at the global level to assist in the adoption of sound practices and providing assistance for the development of robust and efficient financial structures in emerging markets.
   • Third, risk is getting so complicated that it must be managed, at the institutional level, sectoral level and the national level. While the Working Party felt that there is no one checklist that covers all risks in all countries, as a practical man, I find checklists helpful to identify where the risk concentrations are. We have to be practical: there will always be different ways of managing risks and different appetites for risks. Let the market judge how the risks are perceived and managed.
   • Fourth, not only must individual banks manage their risks better, policy makers must manage the national risks more effectively. This implies that they must have a "big picture" of the risks that are concentrating or emerging for the economy as a whole. Traditional risk management at corporate or sectoral level may simply shift risks from one sector to another. Risks still remain in the economy as a whole. Thus, the new approach in financial regulation is all about national risk management.

Brave new world, old-fashioned credit risks

4. In the last two decades, the global financial system has witnessed dramatic changes that have brought about both higher risks and rewards. At the end of the 1980s, I was engaged in a survey of problem financial systems at the World Bank. I counted 33 countries that experienced financial fragility problems, but the 1996 IMF World Economic Outlook reported that out of 180 Fund members, at least 130 suffered banking problems in the last 15 years, many of which surfaced in the 1990s.
5. The structural changes in banking stem from a combination of globalization, financial innovation, de-regulation and liberalization that saw increased competition and capital flows. A few simple numbers would illustrate what I mean. First, between 1986-96, global GDP increased by 42%, world trade by 92% to US$4 trillion, cross-border bank assets doubled to $8 trillion, daily FX tradins increased to $1.3 trillion in 1995 (6 times the volume in 1986), and derivative market trading increased roughly 20 times. As Bob Hope used to say, a billion here, a billion there and soon we are talking about real money.
6. Second, as a result of deregulation and the development of capital markets, banks, insurance and the pension/asset management business are functionally integrating, although banks are still licensed separately. In the US, the mutual fund business is getting almost as large as banking assets. Stock market assets are bigger than banking assets.
7. Third, financial innovation, particularly in the growth of derivatives has introduced a whole new ball game of financial instruments to manage risks. These new instruments also bring with them added risks, as Mr Leeson amply demonstrated with Barings.
8. Fourth, I believe it was Bill Gates who made the interesting point about technology and competition in banking: "in the 21st century, banking will be important, but not necessarily banks." The rise of the Internet has the potential to cut out significantly the intermediation function of traditional banking, since consumers and savers can go directly to the service provider. Software houses, car manufacturers, telephone companies, and even cable TV providers are getting into the online home banking and financial services business. For instance, the cost of intermediation involved in securitization is 50 basis points, compared to 200 basis points using a traditional bank loan. Internet banking, provided the security aspect can be sorted out, costs less than 1 cent per transaction versus US$4 to clear a paper cheque in the US.
9. All these structural developments widen the boundaries of financial markets and add to increased competitive pressures, both functionally, domestically and internationally.
10. I put this in a global context because, as my former colleague at the World Bank, Mr Jerry Caprio used to say, we're not in Kansas anymore. The globalization of capital flows, as international funds roam the world in search of higher returns and lower risks mean that domestic financial systems absorb a tremendous amount of risks without even being aware of the consequences of globalization. Gerry Corrigan, former President of the New York Fed and Chairman of the Basle Committee liked to point out that it was old fashioned credit risks on the asset side of the balance sheet that more often than not got a bank into trouble. On the other hand, financial innovation has meant that banks are increasingly getting themselves also into trouble on the liabilities side in the new world of derivatives. How else can we explain that the Thai banking system entered into US$23.4 bn of forwards, equivalent to nearly 15% of GDP in a matter of days?
11. As recent IMF studies have shown, the costs of financial distress can be very large, with direct fiscal costs ranging from 10-20% of GDP, causing large scale devaluations and severe economic adjustments. We all know that prevention is better than the cure, so that financial regulation is the right thing to do. On the other hand, although no good estimates are available on the costs of financial regulation internationally, one private sector research estimate puts the cost of financial regulation in the US as high as 7% of GDP, with the caveat that excessive regulation may stifle innovation and productivity improvements.
12. The globalization of banking means that increasingly banks have to satisfy both national as well as international scrutiny and oversight. This calls for national supervisors to apply world-wide standards, so as to achieve a level playing field. Different markets should adapt their respective legal framework to enable bank and capital market regulators to cooperate and coordinate better both domestically and internationally.
13. All the new rules of the game are being spelled out in the Basle Committee's 25 Core Principles, and the Working Party Report on Financial Stability in Emerging Market Economies which Gavin has just talked about. I would simply like to add a commentary to some key facets which I feel deserve a bit more elaboration.

The Fallacy of Composition

14. If we think through the key lessons of volatile capital flows, and the fact that global financial markets comprise basically the sum of domestic markets, we begin to understand that markets actually make very basic mistakes of what is commonly called the "fallacy of composition". If everyone believes something to be true, the prophecy becomes self-fulfilling - that is, the herd instinct pushes the price in that direction. To put it very simply, many property developers make the mistake of borrowing short to invest in long-term property. Bankers make the mistake of borrowing short to lend long [especially in property or other asset markets]. And aggregately, some emerging markets make the mistake of borrowing short-term capital flows to finance illiquid non-tradeables, such as property, which cannot generate the foreign exchange to repay foreign debt.
15. This problem is compounded when inexperienced asset fund managers collectively assume that investing in emerging markets mean that you can get higher returns without some risks. In sum, when it does not add up, there is no free lunch.
16. What globalization has brought about is the fact that asset markets are now managed as portfolios, so that foreign fund managers look at an economy in terms of four major asset markets, namely, bank deposits, equity, bonds and the property market. Asset managers look at the quality behind each asset, their risks and returns and while domestic asset holders may shift between internal markets, global markets allow all asset holders (including foreign investors) to shift to foreign assets when conditions are unfavourable domestically.
17. Thus, today domestic policy formulation cannot run independent of all asset prices, namely, the interest rate, the exchange rate, consumer prices and real estate prices. Whenever one market price is not consistent with the fundamentals, and there are policy conflicts, there are sufficient arbitrageurs out there to hedge or arbitrage the price differences.
18. This is particularly true of the foreign currency hedge, which is provided by the domestic banking system. The pricing of that hedge depends on the interplay of the interest rate and the exchange rate. If, for whatever reasons, there is a conflict of policy between these two prices as policy targets, then the domestic banking system may misprice the premium of the hedge. Since the central bank is both the lender of last resort as well as the ultimate provider of domestic foreign exchange, there is the risk that the policy conflict results ultimately in a loss in foreign exchange reserves through intervention.
19. The "fallacy of composition", which occurs because of information asymmetry, causes markets to overshoot or undershoot, adding to volatility. Thus, the only way to deal with this problem is greater market information, disclosure and transparency. In derivative terminology, if the assumptions about the underlying asset behaviour are wrong, the value of the derivatives can be mispriced very badly. It is the banker's job to manage his risks well, hence the new emphasis on risk management models and systems. A banker may have only a micro-picture of his risks, but his board, shareholders and regulators must have a macro-view of where the risks are concentrating. In other words, the market functions well when information about the micro and macro risks in the system are readily available to everyone.
20. In this complex world, we can no longer assume that public policy-makers or regulators have the best information. Given the large element of uncertainty underlying technological progress and the behaviour of markets, Fed Chairman Alan Greenspan puts it succinctly when he "argues for supervisory and regulatory policies that are more "incentive-compatible", in the sense that they are reinforced by market discipline and the profit-maximizing incentives of bank owners and managers."

Let the market work

21. Given the growing complexity of banking business, and derivatives activities in particular, there is now growing consensus among regulators that a common, simple, static and "one-size-fits-all" type of capital rules is inadequate. Rather, banks themselves are in a better position to closely monitor their own risk profile in a timely manner. Regulators should instead assess and try to build on banks' own internal risk control models, and encourage more disclosure for market assessment.
22. As stated earlier, the risks of regulation are that the more the state regulates, the more it underwrites the risks. Even worse, the more badly the state supervises the system, the more it has to pay. Avoidance of such moral hazard problems is thus extremely essential. The Working Party report, for example, highlights the modern supervisory approach of using market discipline and market access channels. It recommends greater transparency through regular and comprehensive disclosure of information. This information will be efficiently used by such entities as rating agencies, credit bureaus and central credit registers to provide incentives for the adoption of sound supervisory systems, better corporate governance and other key elements of a robust financial system. This is an area where the accountants, auditors and professional financial services have a vital role to play to help bankers manage their risks more efficiently and transparently.
23. Here I would like to mention the role of market infrastructure in helping to improve market oversight. The functioning of a modern real-time payment system is a discipline in itself. Real-time delivery versus payment forces a bank to exercise greater operational discipline and impose internal checks and balances in the system. Failure to complete a transaction to settlement immediately informs the market about the weakness of a participant. The problem with old, manual systems is that too much "gapping" is allowed. It is the inefficiency of the system that allows banks to "gap" the maturity or the payment. However, such "gaps" imply huge risks, and the larger the timing gap between settlement and payment, the larger the credit and market risks experienced by the participants. In other words, robust efficient market infrastructure are themselves generators of sound market information for the system to work well.
24. Another important aspect of market discipline is to rely on incentives tied to bank capital; to impose greater personal liability for bank directors; to limit the disincentive effects of explicit or implicit government guarantees and to encourage voluntary market standards or guidelines. These measures directly linked up one's self interest to the risks that he takes for the institution in which he works. Self interests are better incentives than external rules.

The Problem of Bureaucratic Inertia

25. Let me now turn to an inherent problem of financial regulation, which is sometimes called forbearance and otherwise called bureaucratic inertia. It describes the case where even if the regulatory framework is well set out, there runs a risk where problems are delayed before resolution. Regulatory forbearance may be due to a number of factors, including political and/or supervisory interference, a lack of supervisory accountability, the common "wait-and-see" attitude, or fears of legal challenge. In addition, there comes to the more basic problems of the lack of reliable information and the lack of qualified staff.
26. As we all know, the costs of delaying corrective actions can be very high. Weak and undercapitalized banks, if allowed to continue their operation, may escalate the scale of losses. To address the problem of regulatory forbearance, one possible means is to reduce the discretion available to supervisors. The US, for example, have adopted a more rule-based supervisory regime under the Federal Deposit Insurance Corporation Improvement Act of 1991, where particular corrective actions are mandated in accordance to the different level of bank capitalization. However, some argue against this practice, stressing the importance of supervisors' judgment in detecting problems and taking corrective actions at the right time.
27. How do we deal with this problem at the domestic level is clearly a matter for national authorities. But how do we deal with this at the international level, since the contagion costs are clearly rising in a global world?
28. There is no easy answer, and I can only envisage that there should be more dialogue between the multilateral forum and domestic authorities on this issue. The implementation of information disclosure is not something that one can be achieved overnight, so that it is important that there be a period of phasing in information disclosure, as with other areas of financial liberalization. There should be greater discussion how international institutions may help to promote the incentive structure for the adoption of sound policies. Rating agencies, for example, can help strengthen market discipline, as also the proposals for an international rating classifications for financial systems in different countries (Honohan, 1997). This is an area where I keep an open mind and would like to hear different views on how to proceed.

Checklist for Risk Management

29. If we think through it more carefully, financial regulation is essentially all about risk management. John Nugee, my former colleague who currently manages foreign exchange reserves in the Bank of England, used the acronym "ICAC" [the Hong Kong Independent Commission against Corruption] to describes the evolution of risk control systems. He pointed out that most institutions tend to initially Ignore the risks. But when they realize that risk exists and must be recognized, they Calculate it and are usually shocked by the size of risk involved. Nevertheless, management should realize and accept that their objectives are not to Avoid but to Control risks, as higher returns are always associated with higher risks.
30. Earlier this year, the Bank of Japan has introduced a new set of checklist for risk management. This new checklist emphasizes the actual control of risks involved in different operations and addresses that different types of risks may occur in a single operation. In a way, the distribution of risks are clearly shown and any risk concentration can be immediately identified. The checklist is reproduced in the Annex.
31. The Checklist approach is good for sectoral risk management, but that is not the end of the story. There is a need for us to take a broader view and look at risk management not only from the sectoral level, but also from the national perspective.

Towards National Risk Management

32. As a result of the large losses of banking system, the problem of moral hazard [whereby the private sector gains at public cost] has become a major issue. The greater the regulatory coverage, the greater the risks of moral hazard, since the public assumes, not without reason, that the purpose of regulation is protection. However, excessive protection ends up paying the market price of inefficiency and bailout costs. In other words, hedging techniques often pass the risks between sectors [such as public underwriting of deposit insurance], but does not avoid the risks of bank failure at all and may under some circumstances add to the risks of failure. Consequently, increasingly in the 1980s, there emerged the awareness that financial sector regulation was all about national risk management.
33. This is because optimal policies at the sectoral level may not be consistent with each other and the resulting net position may not be optimal when the nation is considered as a single entity. At the national level, there must be a coordinator to synchronize risk management approaches of different sectors; to take an overview of the national risk profile and to manage risks for the good of the whole economy.
34. Just as corporations controls firm risk based on asset-liability management, a policy maker should apply national asset-liability management techniques, using a national balance sheet approach. Some general national risk management rules include (Sheng and Yoon, 1993):
    • fostering price stability to reduce system-wide risks and uncertainties for private sector initiatives; fiscal discipline is a key anchor of price stability;
    • asset diversification: to broaden the production and export structure to ensure competitiveness at international levels; and to build up foreign exchange reserves when the domestic asset base is highly concentrated;
    • liability management: reduce national and sectoral leverage by strengthening the capital base of corporations and banks; deepen domestic financial markets; improve debt management and avoid large maturity, interest rate and exchange rate mismatches;
    • develop institutional and administrative capacity to assess risk and to contain systemic risk;
    • sequence financial sector liberalization measures with a clear understanding of the risks involved, and with appropriate institutional strength and fiscal resources to manage the transitional process without losing macroeconomic stability.
35. These principles of economy-wide risk management were applied in Hong Kong, where supervisory coordination is achieved by close liaison between the banking, securities and insurance regulators, who all report to the Financial Secretary. In order to alleviate the concentration risks of mortgage lending in banks, the Hong Kong Mortgage Corporation was created this year, which will extend the maturity profile of banks, improve the liquidity of mortgages and help spread the property risks to long-term holders outside the banking community. To improve market transparency and reduce payment and settlement risks, a modern, streamlined real-time gross settlement (RTGS) payment system became operational in Hong Kong in December last year. This would enable financial market participants to minimize huge settlement risks by being able to practice Delivery versus Payment, and Payment versus Payment.
36. Global financial markets are still at the stage of transition. Many economies have not yet totally abandoned exchange control, since their currencies and markets are still not fully liberalized. Consequently, policies and practices at the micro and macro-level very often assume that the degrees of freedom still exist as in a closed economy model. On the other hand, the pace of liberalization has gone far enough in many economies for them to have lost the ability to control all the key economic variables at the same time. It is therefore not surprising that policy outcomes are quite different in the new open market environment.
37. In that sense, the market discipline is already operating on domestic economies and financial systems. Those systems that function well will be rewarded by capital inflows, while those that have inefficiencies ultimately face the prospects and pain of potential capital outflows. We are certainly not in Kansas anymore.