Do markets enhance convergence on international standards? The case of financial regulation
Hyoung-Kyu Chey, Northeast Asian Economics Studies Team, Institute for Monetary and Economic Research, The Bank of Korea, 110, 3-Ga, Namdaemum-Ro, Jung-Gu, Seoul, South Korea. Email: firstname.lastname@example.org
Why do countries that did not participate in the establishment of international standards converge on them in the absence of external coercion? The market-based perspective asserts that market forces enhance cross-national convergence on international standards. This paper challenges the market-based perspective, focusing on compliance with the 1988 Basel Capital Accord in South Korea and Taiwan. First, it argues that adoption of the Basel Capital Accord by these countries was mainly driven by their regulatory authorities’ concern about the potential risk of foreign market closure to noncompliant banks. Second, it demonstrates that enforcement by the two countries’ regulatory authorities was crucial in ensuring compliance. These findings suggest that national regulatory authorities are still key actors in voluntary convergence on international standards.
One of the most noteworthy features of recent global economic governance, particularly in the area of finance, is the growing reliance upon so-called voluntary international standards or best practices in regulating the behavior of private sector actors.1 Most of these standards have been formulated through cooperation among a limited number of developed countries, with the participation of private sector actors, or sometimes by private sector actors themselves.2 The participation of less developed countries in the establishment of these standards has been quite limited;3 nevertheless, a large number of less developed countries have voluntarily adopted and complied with such standards,4 even in the absence of substantial efforts on the part of international financial institutions, such as the International Monetary Fund (IMF) and the World Bank, or of the countries that established the standards, to coerce such compliance.5 Given the significant short-term adjustment costs, and the uncertainty of the benefits to be gained from such cooperation (Drezner 2003, p. 5), this convergence on international standards by less developed countries is surprising. This raises an important question concerning global financial governance: Why do countries that did not participate in the establishment of international financial standards voluntarily converge on them?6 This paper addresses this issue, paying particular attention to one critical potential cause of convergence: market pressure.7
Many scholars have emphasized market forces in explaining voluntary convergence on international financial standards.8 According to this market-based perspective, international finance is characterized by information asymmetries, and the adoption of a particular regulatory standard by a firm signals its reliability as a counterparty in business agreements. In this environment, complying with an appropriate regulatory standard constitutes a competitive advantage (Simmons 2001, p. 602, 2006, p. 11). Markets perceive firms that do not comply with international standards as poorly regulated, and hence noncompetitive, and penalize them accordingly. Owing to these market pressures, governments concerned with the competitiveness of their financial sectors adopt the relevant standards, and firms comply with them so as to avoid market penalization. According to this line of argument, market forces thus induce convergence on international standards by leading governments and firms to comply with them.9 The idea that market forces can enhance compliance with international standards is largely accepted by practitioners at international financial institutions.10
However, there are two serious problems with this market-based perspective. First, the literature based on it tends to assume, rather than demonstrate, that the market serves as a natural enforcer of international financial standards. Indeed, few comprehensive empirical studies have actually demonstrated the operation of market pressures for compliance with international financial standards. Moreover, the literature pays scant attention to national regulatory enforcement as an important source of market pressures for compliance with international financial standards. Market participants may pressure firms to comply with an international financial standard because they perceive it as increasing firms’ competitiveness, but they may also do so merely because they expect noncompliant firms to be penalized by the national regulatory authorities.
Do markets actually play a critical role in voluntary cross-national convergence on international financial standards? I attempt to answer this question by examining (i) why the 1988 Basel Capital Accord (hereafter Basel Accord or Accord) was adopted by the governments in South Korea (hereafter Korea) and Taiwan, and (ii) why banks in these countries complied with the Accord. These two questions may be regarded as separate. However, the inclusion of both issues in the analysis is necessary for understanding all aspects of these countries’ convergence on the Accord; indeed, their convergence became complete only when their governments had adopted the Accord (government compliance) and their banks had complied with it.11 In addition to satisfying this analytic need, clear recognition of these two distinct stages of convergence enables exploration of whether there were any differences in the role of market forces during the two stages.12
The Basel Accord was established in 1988 by the Basel Committee on Banking Supervision (hereafter Basel Committee), which consisted of central banks and bank supervisory authorities from Group of Ten (G10) countries. The Accord had two objectives: to strengthen the soundness of the international banking system, and to level the playing field for international banks. To achieve these objectives, the Accord formulated a common framework for measuring banks’ capital adequacies and set a required minimum capital adequacy ratio (CAR) at 8%.
Even though the Basel Accord was initially agreed upon by G10 countries only, it has since been voluntarily adopted by more than 100 countries (BCBS 2004), making it a suitable research subject for the student interested in voluntary convergence on international standards. Among the various international financial standards, it is also particularly well known to market participants (FSF 2000, p. 20). There was thus a high likelihood that the markets would put pressure on banks to comply with the Accord. Indeed, proponents of the market-based perspective frequently refer to the Basel Accord when stressing the role of market pressures in bringing about convergence and/or compliance.13
This study focuses on Korea and Taiwan, two countries that have never been members of the Basel Committee. Given the increasing vulnerability of these countries’ banks to market forces due to growing financial liberalization in the late 1980s and the 1990s, compliance with the Basel Accord by these two countries appears to be “most likely cases” of market-driven convergence on international standards.14 Furthermore, these two countries would also appear to be “least likely cases” of state-led convergence in that the Korean and Taiwanese regulatory authorities’ intentions to use the Accord to strengthen the soundness of their banking sectors were weak.15 In addition, neither Korea nor Taiwan faced substantial direct pressure from foreign countries – including Basel Committee countries – to comply with the Accord, except during the period that Korea was under the IMF program (1997–2000) in the wake of the 1997 Asian financial crisis.16 Thus, analysis of the convergence of Korea and Taiwan on the Basel Accord can provide insights into whether market pressures play a key role in inducing voluntary compliance with international standards.
This paper is organized as follows. I first discuss distinct types of compliance pressure that may lead to convergence on international standards, and then I analyze how market participants responded to the Basel Accord. I next examine the factors that led Korea and Taiwan to adopt the Accord. Finally, I address why banks in the two countries complied with it. My research indicates that it is government, rather than markets, that best explains the Korean and Taiwanese responses to the Basel Accord. The Korean and Taiwanese regulatory authorities’ concern about potential foreign market closure to banks that failed to comply with the Accord was the major factor leading those countries to adopt the Accord. Enforcement by the authorities also played a decisive role in ensuring that Korean and Taiwanese banks complied with the Accord. To be sure, market forces and the threat of foreign market closure did give banks additional incentives to comply, but such external compliance pressures largely reflected domestic regulatory enforcement.
Diverse sources of compliance pressure
Pressures for compliance with international standards can stem from diverse sources. The market-based perspective maintains that market forces are a key source. The state, in particular the regulatory authority, is another important, and a more traditional, source of compliance pressure on domestic firms. Firms may also face compliance pressures from foreign states.
The market-based perspective asserts that market forces operate in such a way as to ensure compliance with international regulatory standards.17 International standards may provide a focal point for market participants against which they evaluate firms’ competitiveness. If market participants credit an international standard as desirable, they will consider firms not conforming to it as noncompetitive and penalize them accordingly. When such market pressures for compliance with a standard are at work, all firms that the standard applies to will face these pressures, regardless of their home countries’ adoption of it. Therefore, voluntary international standard compliance by countries not obligated to comply can be induced by market forces.
Market compliance pressures such as these are unlikely to arise easily, however, especially relative to international standards established by national authorities with limited market participant involvement. First of all, for such pressures for compliance to operate, market participants need to be familiar with the standard and they need to understand it and its potential value to them (Mosley 2003, p. 352). Furthermore, market participants should agree both on the general objectives and desirability of the standard and on the appropriateness of the specific rules the standard prescribes. In general, however, national authorities tend to place more weight on the “public good” aspect of regulations, whereas market participants tend to care more about efficiency. Also, regulatory standards formulated by national authorities tend to lag behind market innovation (Tamura 2003, pp. 48–49). Therefore, market participants may disagree on the detailed rules of an international standard, even if they agree on its generic objectives or principles. All of these factors make the emergence of pure market pressures for international standard compliance extremely difficult in practice, contrary to expectations of the market-based perspective.
States, in particular national regulatory authorities, are the more traditional source of pressure for compliance with regulatory standards. However, the prevalence of the market-based perspective means that their role in international standard compliance may have been somewhat underestimated. Yet, states do have the power to regulate firms within their own jurisdictions. Moreover, the operation of state pressure for international standard compliance leads markets to apply compliance pressures as well. Once a standard has been implemented within a country, and there are regulatory penalties for noncompliance, noncompliant firms will suffer those penalties. Such regulatory penalization has negative effects on firms’ business. Also, given that noncompliance by a firm will trigger regulatory actions, failure to meet such an important standard may imply that the firm involved has serious problems. Therefore, market participants pay close attention to firms’ compliance with the regulatory standards to which they are subject and penalize firms failing to meet those standards.
These market compliance pressures emerge as a result of compliance enforcement by national authorities. Therefore, they differ from the pure market compliance pressures indicated by the market-based perspective. Market compliance pressures based upon regulatory enforcement are additional pressures that stem from market actors’ expectations of compliance enforcement by national authorities. Without regulatory enforcement by national authorities, no such pressures emerge, even for compliance with international standards.
Foreign states are another salient source of pressure for compliance with international standards. One way in which a state can lead foreign firms to comply with standards is by directly pressuring the firms’ home states. However, in the context of certain international standards aimed at international firms, states, especially those with large markets, have an additional effective means of punishing foreign firms for noncompliance: they may induce foreign firms operating in their jurisdiction to comply by threatening the closure of their markets to firms that do not (see also Drezner 2003, 2005). The direct effect of such threats is of course limited to foreign firms operating or wishing to operate within such countries. However, a national regulatory authority concerned about the overseas business activities of its nation’s firms may be moved to adopt the international standards domestically.18 This kind of threat of market closure constitutes compliance pressure from a foreign state, not from decentralized markets.
Clear recognition of the differences between these three distinct sources of compliance pressure is critical for understanding the role of market forces in convergence on or compliance with international standards. However, most studies based on the market-based perspective fail to make these essential distinctions; in particular, they conflate pure market compliance pressures and pressures based on compliance enforcement by national regulatory authorities, with the latter frequently misunderstood as the former. The following sections explore which type of compliance pressure was the main factor in leading Korean and Taiwanese convergence on the Basel Accord.
Market responses to the Basel Accord
The CAR in the Basel Accord (hereafter BIS CAR)19 was computed by dividing total capital by risk-weighted assets on a consolidated basis. Capital was divided into tier 1 (core) and tier 2 (supplementary) capital. The total of the tier 2 elements was limited to a maximum of 100% of the total of the tier 1 elements. Risk weights of 0, 10, 20, 50, or 100% were applied to assets in accordance with their types. It was formally intended that the Basel Accord be fully applied to international banks from the G10 countries from the end of 1992.
How did the market respond to the Basel Accord? In addressing this issue, this study focuses mainly on how the credit rating companies (CRCs) incorporated banks’ BIS CARs in rating them. Credit ratings are an important, integral component in investors’ credit risk management strategies, and a bank’s credit rating thus significantly affects its market operations, including its borrowing costs. For instance, a survey of 260 leading financial institutions and business corporations shows that approximately 90% regard credit ratings as “one of the most important sources of information for determining rating internally,” or as “one of a variety of external sources of credit data (though not the most important) taken into account when assessing credit risk internally” (JCIF 2000).20 Indeed, according to one estimate, due to the greater security it offered, an “AAA”-rated bank could issue debt paying interest of between 0.1 and 0.6% less than an “AA”-rated bank (Bennett 1991). Although credit ratings are mainly issued for investors, most banks disclose their credit ratings to the public as well, and depositors also take bank credit ratings seriously. Therefore, this analytical shortcut of focusing on CRCs in addressing the market’s response to the Basel Accord is appropriate.
From its outset, the Basel Accord was widely criticized for its failure to incorporate key insights from finance theory (see Thomson’s International Banking Regulator 1991).21 The risk measurement framework of the Accord did not generate capital advantages for banks with well-diversified portfolios, which should have been treated as less risky than banks whose portfolios were more concentrated. The Accord’s system of five risk-weight categories was crude. The required minimum CAR of 8% was arbitrary and was not based upon any particular insolvency probability standard. The different risk weights for Organisation for Economic Co-operation and Development (OECD) and non-OECD countries were also arbitrary and politically motivated. The Accord did not cover various forms of risk, such as operation risk. Additionally, financial market innovation, in some cases with the intention of circumventing the Accord, further eroded its effectiveness (Greenspan 1998, p. 165; Karacadag & Taylor 2000, pp. 5–7). As a result of all these problems, the relationship between a bank’s compliance with the Accord and its soundness was doubtful.22
As a result, the CRCs did not view the Basel Accord as a reliable solvency regulation, and so they did not consider the BIS CAR a dependable solvency indicator.23 They examined banks’ BIS CARs and also frequently referred to them when altering bank credit ratings; however, after examining a bank’s BIS CAR, the CRCs would adjust it to calculate the bank’s economic capital ratio by taking into account various additional factors. The underlying logic of the economic capital ratio is that a bank’s true economic capital should be permanent and readily available for weathering massive losses before general creditors are affected in any way (Moody’s 1999a, p. 37). It was these capital ratios that influenced the CRCs’ rating decisions, and they relied on their own in-house models in evaluating banks’ economic capital ratios.24 Furthermore, the CRCs understood that the proper levels of capital that banks needed to hold differed in accordance with their varying risk profiles.25
Discrediting the Basel Accord, in their ratings the CRCs were indifferent to whether a bank had adopted it or not. One analyst at Standard & Poor’s (S&P), one of the “big three” CRCs, commented, “Standard & Poor’s did not [penalize banks that did not adopt the Basel Accord]. Rather, Standard & Poor’s relies on its own assessment of the appropriate level of capital it considers a bank would require, given the bank’s risk profile.”26 In other words, it was not a form of the CAR that affected a bank’s ratings. Accordingly, there was no CRC pressure on banks to adopt the Basel Accord.27
Given the CRCs’ distrust of the Basel Accord, it is not surprising that there was no positive association between banks’ BIS CARs and their credit ratings. Moody’s Investors Service (hereafter Moody’s), another one of the three largest CRCs, expressly stated this in its bank-rating methodology (Moody’s 1999a, p. 29): “[M]oody’s sees no automatic correlation between a bank’s level of regulatory capital and its credit ratings.” It also said “Regulatory ratios give a very imprecise indication of capital strength. This is so even when regulatory capital ratios are based on risk-weighted models, such as the Basel criteria” (Moody’s 1999b, p. 32, author’s emphasis).28Fitch Ratings (2003), the third big CRC, also reported the correlation between its long-term credit ratings and banks’ tier 1 capital ratios to be mildly negative, except in the case of a group of major international banks. Market compliance pressures, insofar as they can be gauged by CRC credit ratings, therefore, did not operate in relation with the Basel Accord.29
It should be emphasized that the CRCs’ neglect of the BIS CARs was not just a recent (from the late 1990s) phenomenon. Even during the early and mid-1990s, the link between banks’ BIS CARs and their credit ratings was weak.30 For example, S&P’s Long-Term Issuer Credit Rating for Korea First Bank remained stable at A− during three consecutive rating assessments in June 1993, December 1993, and June 1995, while between December 1993 and December 1995, its BIS CAR fell from 10.2 to 8.7%. The bank’s S&P Short-Term Issuer Credit Rating did not change either during three consecutive rating assessments in June 1993, June 1995, and July 1996.31
In sum, from the perspective of market participants, there were several flaws in the way that the Basel Accord assessed the actual capital soundness of banks. Market participants thus did not accept the Accord as a reliable regulatory standard, with the result that pure market compliance pressures did not operate relative to it. What factors, then, led Korea and Taiwan to adopt the Basel Accord?
Non-member incentives to follow
Although there was no market pressure to adopt the Basel Accord, its adoption in Korea and Taiwan proceeded quickly. The Taiwanese regulatory authorities incorporated the principles of the Accord in their banking regulations by amending the banking law in July 1989, and required that Taiwanese banks comply with the Accord from 1992, when banks in Basel Committee countries were also required to do so. Although Korea lagged behind Taiwan somewhat, in October 1991 the Korean authorities also announced a plan to adopt the Accord and began to implement it in 1993.32
The major reasons for adopting the Basel Accord in Korea and Taiwan were their national regulatory authorities’ concern about foreign market closure to noncompliant banks.33 The Basel Committee did not explicitly pressurize non-Committee countries, including Korea and Taiwan, to comply with the Accord.34 From the very outset, however, in international meetings of bank regulatory authorities, the Committee did encourage countries to adopt it, and provided them with technical assistance for doing so (Simmons 2001, p. 605).35 Major countries, including the US, also took the implementation of the Basel Accord into account when approving foreign banks’ applications to expand activities within their markets (see Gruson & Reisner 2000; FSF 2001, p. 54). These activities of the Basel Committee and major countries gave Korean and Taiwanese authorities the perception that strengthening capital adequacy standards was an international trend and that the Basel Accord would become the main criterion for judging banks’ capital adequacy.36
The Korean and Taiwanese regulatory authorities accordingly concluded that adopting the “international standard,” the Basel Accord, was necessary to protect their banks’ business operations in major countries (OBS 1991).37 Moreover, foreign branches of banks from non-Basel Accord countries – including Korea and Taiwan – were indeed sometimes required to submit their BIS CARs to foreign authorities (KEB 1991).38 The Korean and Taiwanese perception was not necessarily irrational, therefore, as they felt that there was a real chance of Basel Committee countries tightening their rules on foreign bank branches at some future time.39 Ultimately, Basel Accord adoption by Korean and Taiwanese regulators was designed to counter foreign criticism of their banking regulation.40
Given that the majority of Korean and Taiwanese banks’ overseas footholds were located in Basel Committee countries, this was a strong incentive for Korea and Taiwan to adopt the Accord. At the end of September 1988, approximately 60% of Korean banks’ overseas establishments were located in Basel Committee countries (Son & Choi 1989, p. 71), as were more than 60% of Taiwanese banks’ in 1990 (BOMA 1992, p. 8). The Korean government was also encouraging Korean banks to establish branches overseas so as to support the rapidly proceeding internationalization of Korean firms (Lee et al. 2004, pp. 539–542). The Taiwanese government was also striving for the internationalization of Taiwanese banks in the late 1980s and the 1990s in order to develop their international banking activities, promote international trade, and meet Taiwanese firms’ demands regarding investment and marketing abroad (BOMA 1992, p. 51; 1996b, pp. 63–65). In these circumstances, the Korean and Taiwanese regulatory authorities needed to prevent risk to the overseas activities of their countries’ banks.
Regulatory enforcement and banks’ compliance
The compliance of Korean and Taiwanese banks with the Basel Accord was quite thorough during the 1990s and early 2000s.41 Between 1993 and 1996, all Korean banks – excluding one in 1993 and one in 1995 – maintained BIS CARs above the required minimum rate of 8%. In the wake of the 1997 financial crisis, of course, a majority of them failed to meet the required BIS CAR minimum; however, their capital conditions began to recover in 1999, and all banks cleared the required 8% minimum from 2000 through 2006. In Taiwan, meanwhile, only one or two banks failed to meet the required 8% minimum in most years prior to the late 1990s. The number of compliance failures increased slightly during the late 1990s and early 2000s, reaching about one-tenth of all Taiwanese banks. However, even this compliance record during that period should be seen as reasonably good given the severe downward pressures on Taiwanese banks’ BIS CARs due to the country’s then sluggish domestic economy.
The fairly high degree of Korean and Taiwanese bank compliance with the Basel Accord was primarily attributable to compliance enforcement by the domestic regulatory authorities. The Korean authorities were granted legal power from 1991 to impose sanctions on banks failing to comply with capital adequacy regulations. Such regulatory sanctions could substantially limit banks’ managerial and operational freedom (see OBS 1992). However, until the outbreak of the 1997 financial crisis, the authorities in fact had the discretion to exercise regulatory forbearance with regard to noncompliant banks and actually had little intention of penalizing banks for noncompliance.42 Nevertheless, the overt existence of regulatory penalties for noncompliance led banks to comply with the Basel Accord.43
After the 1997 crisis, the Korean government carried out two rounds of financial sector restructuring and used the BIS CAR as its criterion for determining whether to allow a bank to remain in the market or to close it. In April 1998, moreover, the new financial regulatory authority, the Financial Supervisory Commission, adopted a Prompt Corrective Action (PCA) system based upon the BIS CAR (and the CAMEL rating),44 such that banks with BIS CARs below 8% faced automatic regulatory penalties, including possible closure. During the post-crisis period, Korean banks thus had to meet the required BIS CAR minimum of 8% at all costs in order to survive or at least to avoid regulatory penalties.
Regulatory enforcement was also the primary factor inducing Taiwanese banks to comply with the Basel Accord. The penalties that the Taiwanese authorities could impose for bank noncompliance were explicitly laid out in the banking law of 1989.45 A PCA system was not implemented in Taiwan, and the regulatory authorities could exercise discretion in taking action; however, they were very determined to punish noncompliant banks, and the scope of penalties imposed for noncompliance was broader in practice than the provisions prescribed by law (see BOMA 1996a, p. 47).46 Regulatory penalties for noncompliance with the Basel Accord were strengthened during the early 2000s, when Taiwanese banks’ financial conditions had weakened. As a consequence of the Accord’s implementation, Taiwanese banks were under strong pressure from regulators throughout the 1990s and the early 2000s to comply with it.47
The salience of domestic regulatory enforcement in inducing Korean and Taiwanese banks to comply with the Basel Accord is strongly supported by the following five findings. First, Korean banks established measures to improve their CARs for the first time in their business plans for 1992 (Rym 1992), responding to the regulatory authorities’ October 1991 announcement of their plan to implement the Accord.48 Second, although the CRCs did stress the importance of banks complying with the required BIS CAR minimum of 8%, the reason for this was that banks’ failures to do so could trigger regulatory actions against them (see Moody’s 1999a, p. 37, 1999b, p. 32; TRC 2004).49 Third, adoption of the Accord in Korea and Taiwan led to banks in those countries facing pressures for Accord compliance from foreign regulatory authorities as banks had to at least comply with their home country regulations to do business in most foreign countries (see Chey 2006b, ch. 4). Fourth, although pressures by foreign regulatory regulators encouraged Korean and Taiwanese banks with overseas presences to comply with the Accord to some extent, they cannot explain the compliance by Korean and Taiwanese banks operating only domestically.50 Finally, the punishments for Accord noncompliance that the domestic authorities could mete out were much harsher than those that foreign regulators or markets could impose, in the sense that domestic regulatory actions could pose immediate threats to banks’ managerial freedom, which is naturally a major concern of most banks. All in all, it can be seen that the preeminent reason for Korean and Taiwanese bank compliance with the Basel Accord was to prevent regulatory action on the part of their domestic regulatory authorities.
The main question of this study has been this: Why do countries that did not participate in the creation of international standards voluntarily comply with them? Contrary to assertions from the market-based perspective, this study has shown that market compliance pressure was not a major cause of either Korea’s or Taiwan’s convergence on the Basel Accord. Accord adoption in these countries resulted from their domestic regulatory authorities’ concern about the potential risk of market closure in major foreign countries. Banks’ compliance with the Accord in Korea and Taiwan was primarily because of domestic regulatory enforcement. After the Accord had been implemented in these countries, market pressures for bank compliance did appear. However, these market compliance pressures resulted from compliance enforcement by the domestic authorities. All of these findings suggest that national regulatory authorities are still key actors in voluntary convergence on international financial standards. This is an important contribution to the “state versus market” debate in international political economy.
The findings shed light on three other important issues related to global financial governance. First, they suggest that the establishment of voluntary international financial standards does not in itself ensure financial stability. For a voluntary international standard to be effective, there should be a strong incentive for national regulators to enforce firms’ compliance with it. In the case of the Basel Accord, this incentive stemmed from concerns about the potential risks of foreign market closure. However, a more desirable way to increase such incentives may be to enhance regulators’ voluntary belief in the desirability of the standard. Including regulators from various countries in the process of establishing international standards may help to increase regulators’ voluntary support for them.
Second, this research indicates that the effect of regulatory authorities as the core enforcer of international standards is increasing with the globalization of markets, as markets amplify the compliance pressures originating from these authorities. This implies that the strengthening of the enforcement capacities of regulatory authorities would effectively raise international standard compliance.
Finally, this study analyzed the reactions of the CRCs, influential market actors, to a major international financial standard, the Basel Accord. The fact that the CRCs were essentially at odds with the Accord suggests that private and public regulation may stand on opposing sides, even though private regulation may support formal compliance with public regulations.
Our ability to generalize this study’s findings across various international standards is somewhat limited. Two key reasons are that the establishment of the Basel Accord did not embrace much input from market participants (Mosley 2005, p. 29) and that it was a poor regulatory standard from the perspective of actual capital adequacy. Indeed, Mosley (2003, 2005) argues that the more private sector actors are involved in establishing international standards, the stronger the market compliance pressures on them are likely to be. The national regulatory authorities themselves, moreover, may also have capacities to devise good international standards acceptable to market actors.51
It should be noted, however, that even if market actors have participated in standard formulation, and even if the standards in question were good ones at the time of their establishment, market actors may continue to call for their amendment as market innovations continue. In this situation, it may not be surprising that amendments will lag behind such demands from the markets. Accordingly, even though markets have initially accepted an international standard, the period of acceptance would turn out to be very short. Moreover, there is usually a transitional period of some years between the establishment and implementation of an international standard. By the time implementation actually begins, from the market viewpoint that standard may already be obsolete.
This doubt concerning the market support for compliance with better or more market-oriented international standards is speculative, and considerable work needs to be done here. One promising subject for future research in this regard is the convergence of non-G10 countries on Basel II (which replaces the 1988 Basel Accord from 2007). Market actors, including the CRCs, actively participated in establishing Basel II, which is generally regarded as offering better regulation than the crude 1988 Accord. Moreover, Basel II explicitly includes elements aimed at enhancing market compliance pressures. Nonetheless, my preliminary research indicates that the CRCs will continue using their own methodologies in analyzing bank soundness, rather than Basel II (see S&P 2003), supporting skepticism about the possible operation of pure market pressures for compliance even with better or more market-oriented standards. This paper’s findings, however, should be substantiated by additional research.
I wish to thank Andrew Walter, the editors, and four anonymous referees for their helpful comments on an earlier version of this paper. I am also indebted to all those who participated in interviews. Research was accomplished when I was a PhD candidate at the London School of Economics, and the views expressed in this paper do not necessarily represent those of the Bank of Korea.
For examples of international financial standards, see Mosley (2005, p. 9). The real targets of most international regulatory standards in areas such as finance, accounting, the environment, and labor are private firms (Börzel 2000, pp. 2–3).
For the growing role of private sector actors in global economic governance, see Cutler et al. (1999), Farrell (2003), Hall and Biersteker (2002), Mosley (2005), and Ronit and Schneider (2000).
Although participation in global financial governance by less developed countries has increased since the late 1990s, their influence over most international financial standards is still quite low. For the problems associated with participation in global economic governance, see Drezner (2002, 2003), Germain (2001, 2004), and Mosley (2005).
Note that establishing international standards is one thing, while getting countries to adopt and comply with them is quite another.
The IMF and the World Bank do assess countries’ compliance with international financial standards. However, such monitoring is not usually followed by coercive measures to penalize noncompliant countries, unless they have obtained IMF/World bank financial aid.
In this paper, the terms converge and convergence relate to the phenomenon of countries adopting and complying with an international standard that they did not help to create. Convergence differs from harmonization, which refers to the purposive creation of an international standard by regulators (Singer 2004, p. 532).
For the literature on policy convergence, see Drezner (2001), Elkins and Simmons (2005), Hoberg (2001), and the October 2005 special issue of the Journal of European Public Policy. The literature indicates a number of factors that may lead to cross-national policy convergence. However, a full discussion of all such factors is beyond the scope of this paper.
See, for example, Goldstein (2000, p. 32), Ho (2002), Kapstein (2006, pp. 9–10), Mosley (2003, 2005), Porter (2001, p. 433), Simmons (2001, 2006, pp. 11–12), Singer (2004, p. 563), and Vojta and Uzan (2003). A major alternative theory of voluntary convergence asserts that it results from the spread of common knowledge, norms, and beliefs among regulators. For more on this theory, see, for example, Finnemore and Sikkink (1998).
There is a difference in the degrees of importance different scholars attach to market forces in leading convergence. However, in general, all proponents of the market-based perspective agree that markets can play a critical role in ensuring compliance with international financial standards.
See BIS (1992, p. 20), Evans (2000), FSF (2000, 2001), and Jordan and Majnoni (2002). For example, the “12 Key International Standards for Sound Financial Systems” promulgated by the Financial Stability Forum and the so-called Basel II, which will be discussed in the final section, explicitly intend use of market forces as a key to facilitating compliance.
Many observers of compliance have found that a number of countries readily announce their adoption of international standards, while their actual implementation lags behind. See, for example, IMF (2004).
In analyzing Japan’s compliance with the Basel Accord during the late 1990s and early 2000s, Chey (2006a) argues that mere formal compliance with international standards does not necessarily ensure their effectiveness. However, this paper limits its analytic focus to formal compliance because of the complexity that arises in analyzing what Chey calls “comprehensive compliance.”
See, for example, BIS (1992, p. 20), Ho (2002), Mosley (2005, p. 29), Simmons (2001, 2006, p. 11), and Singer (2004, p. 563).
For financial liberalization in Korea and Taiwan, see Thurbon (2001) and Zhang (2002).
Until the outbreak of the 1997 Asian financial crisis, Korean regulatory authorities did not really intend to use the Basel Accord to improve banking regulations, as they effectively maintained a “no bank failure policy,” while a main objective of the Accord was to prevent bank failures (Chey 2006b, ch. 3, 4). Meanwhile, the Taiwanese regulatory authorities had some expectation that adoption of the Accord would benefit the stability of the Taiwanese banking system, but this expectation was not the main reason they employed the Accord (Chey 2006b, ch. 3, 4). The fact that the Korean and Taiwanese regulatory authorities had little intention of using the Basel Accord to strengthen their domestic regulations implies that the implementation of the Accord in Korea and Taiwan did not arise from policy convergence caused by the spread of shared knowledge, norms, and belief among regulators.
The author’s interviews with Wang Jiunn-Chih (former Director of the Bureau of Monetary Affairs [BOMA], Ministry of Finance of Taiwan, Taipei, 1 September 2004) and anonymous interviewee I (senior Financial Supervisory Service [FSS], Korea official, Seoul, 28 January 2005). However, explicit pressures from the US and the UK on other Basel Committee countries, in particular Japan, did play an important role in the establishment of the Basel Accord in 1988. See, among others, Chey (2006b, ch. 4), Kapstein (1994), and Oately and Nabors (1998).
A group of scholars has asserted that market forces may disrupt regulations established by public authorities. See, for example, Chan and Rose (2003), Falk (1997), McKenzie and Lee (1991), and Strange (1996). The “race-to-the-bottom” theory lies at the center of this argument. However, an enormous number of empirical studies counter this theory (Drezner 2002, p. 8). Indeed, it is widely recognized that the optimal system for economic activities is not a regulation-free world. See, for example, Levi-Faur (2005, p. 14).
In avoiding the threat of foreign market closure, regulatory authorities do not in principle need to apply international standards to firms not engaged in international business. Japan, in fact, has not applied the Basel Accord to banks without overseas branches or representative offices (Chey 2006a). However, many regulatory authorities apply international standards to both international and domestic firms, largely in order to level the playing field between them in domestic markets.
BIS stands for Bank for International Settlements. I use the term BIS CAR here because the Basel Accord is often called the BIS capital adequacy standards.
See also JCIF (1999, 2001), FFH (2003), and Ito and Harada (2000, p. 18).
See also Kapstein (2006, p. 8) and Karacadag and Taylor (2000, p. 5).
An IMF working paper (Sundararajan et al. 2001) shows the direct influence on credit risk and bank soundness of compliance with the Basel Core Principles for Effective Banking Supervision, which include the Basel Accord, to be insignificant. A recent World Bank working paper (Demirguc-Kunt et al. 2006) also suggests the lack of a robust linkage between capital regulations and bank soundness.
The bank-rating methodologies of the three major CRCs – Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings – are available at their Web sites: www.moodys.com, www.standardandpoors.com, and www.fitchratings.com.
Fitch Ratings introduced “pure tier 1 capital,” defined as tier 1 capital less tax effect, public funds, and other preferred instruments, in assessing Japanese banks’ actual capital soundness. S&P used “adjusted common equity” as opposed to tier 1 capital and overall BIS capital (Habir 2004, pp. 68–69).
There was a likelihood of less sophisticated market participants, lacking in resources for analysis, using the disclosed BIS CARs in evaluating banks’ soundness.
The author’s interview with an S&P analyst, by email, 11 August 2004.
For example, even though the Daiwa Bank, a major Japanese bank, withdrew from the Basel Accord and switched to the Japanese domestic capital standards in March 2000, the bank’s S&P Long-Term Issuer Credit Rating did not change, remaining stable at BB+ from December 1998 to September 2001.
In relative terms, capital was more important in emerging markets than in developed countries, given that volatility was greater in emerging markets. Yet, Moody’s stressed “Even in emerging markets, small adjustments in capital ratios are often of little consequence” (1999b, p. 31).
One clear piece of evidence that markets generally followed the CRCs in assessing disclosed BIS CARs is that depositors in Taiwan did not shift their money based upon banks’ BIS CARs (Chey 2006b, ch. 7).
In fact, in 1993, the Basel Committee issued a consultation paper discussing amending the 1988 Basel Accord to incorporate market risks (Tamura 2003, ch. 6).
The weak relationship between banks’ BIS CARs and their credit ratings in the early 1990s becomes more obvious looking at the fact that credit ratings for most major Japanese banks remained stable during this period, despite significant fluctuations in their BIS CARs (Chey 2006b, Ch. 4).
Korean banks were required to maintain their BIS CARs at more than 7.25% during the transitional period of 1993 and 1994 but had to meet the required minimum BIS CAR of 8% starting from 1995.
Drezner (2002, 2003, 2005) and Kapstein (2006, p. 10) also mentioned that the threat of market closure in countries with large markets was a major inducement to accepting international standards.
The author’s interviews with Wang Jiunn-Chih and anonymous interviewee I.
One early example of such encouragement by the Committee was the fifth International Conference of Banking Supervisors in 1988. For more on the conference, see Japan Economic Newswire (13 October 1988).
The author’s interview with Wang Jiunn-Chih.
The author’s interviews with Wang Jiunn-Chih and anonymous interviewees II (senior BOMA official, by email, 2 September 2004) and III (former senior Office of Bank Supervision [OBS], Korea official, Seoul, 3 February 2005).
The author’s interview with Wang Jiunn-Chih.
No Korean or Taiwanese banks in Basel Committee countries experienced actual market closure merely as a result of their non-adoption of the Basel Accord, but the Korean and Taiwanese regulatory authorities perceived the possibility of such closure to exist.
Wang Jiunn-Chih, who was in charge of constructing the Taiwanese Basel capital adequacy standards, commented: “If anybody criticized us, we could defend ourselves by arguing that we were in compliance with the international standard [the Basel Accord].”
During the period of Basel Accord implementations, the Korean and Taiwanese regulatory authorities did exercise regulatory forbearance to some extent. As mentioned earlier, however, this research limits its focus exclusively to banks’ formal compliance with the Basel Accord, that is, their compliance with the required BIS CAR minimum of 8%.
The author’s interviews with anonymous interviewees IV (senior FSS official, Seoul, 31 January 2005) and V (senior FSS official, Seoul, 15 January 2005).
The author’s interview with anonymous interviewee VI (senior banker of a major Korean bank, by phone, 26 August 2005).
CAMEL is a bank-rating scheme whose components consist of capital adequacy, asset quality, management, earnings, and liquidity.
A bank failing to meet the required BIS CAR minimum of 8% could be prohibited from distributing its earnings.
The author’s interviews with Wang Jiunn-Chih and anonymous interviewee VII (senior BOMA official, Taipei, 2 November 2004).
The author’s interviews with anonymous interviewees VIII (banker in a major Taiwanese bank, Taipei, 27 August 2004) and IX (banker in a major Taiwanese bank, Taipei, 1 September 2004).
Indeed, Korean banks’ loans to the private sector, whose risk weight was 100%, began to fall from 1992 and declined more rapidly from 1993 as the financial conditions of Korean banks deteriorated. For Taiwanese banks, however, since the time gap between the establishment of the Basel Accord in July 1988 and the Taiwanese authorities’ legalization of Accord adoption in December 1989 is so small, it is difficult to analyze whether Taiwanese banks voluntarily adjusted their behaviors to improve their CARs.
Brian Oak, who was responsible for the Korean banking sector at Moody’s, commented: “The BIS CARs of banks rarely affect their credit ratings. Because the government requires banks to increase BIS CARs, it is important for the banks to do so” (The Seoul Economic Daily, 3 August 2000).
During the early 2000s, roughly half of all Korean and Taiwanese banks had overseas branches, representative offices, or subsidiaries.
I owe this point to an anonymous reviewer.