The Regulatory Reform of Global Financial Markets: An Asian Regulator’s Perspective
Asia was not directly or significantly hurt through financial channels by the global financial crisis, but rather was hurt through trade channels. This article reviews the current regulatory reforms of global financial markets and how these affect Asia. The current crisis has exposed many weaknesses in the existing financial architecture, including the fragmentation of regulatory jurisdiction at the national and institutional levels. What is required is a system-wide and global view of market behaviour. The article uses a network perspective to analyse the issues and to propose solutions. The globalisation of finance and its fragmented regulatory oversight is a collective action problem that easily slips into a tragedy of the commons. Given the fact that there is no unanimity of views on how finance should be structured, there are differences in approaches to the reforms. Because Asian financial institutions and structures are less sophisticated, Asia is still struggling with how to make the financial system more efficient and responsive to real sector needs. The article suggests that Asia needs to identify its financial needs and can develop its markets through greater regional cooperation. Identifying the need to see financial markets as ecosystems through diversity, the article suggests that Asia can evolve through simpler but more robust financial systems.
- • As a matter of priority, Asia needs to strengthen domestic capital markets according to international standards.
- • The Asian approach will tend to be more pragmatic, focusing on simpler rules more effectively enforced. Financial innovation should be encouraged with an emphasis on functionality for the real sector, rather than leverage for the financial system.
- • Using the network approach means that Asians should build financial markets on a modular basis, ensuring that failure of one module will not destroy the whole system.
- • Since it is recognised that global problems cannot be solved at national levels alone, Asia can increase its voice in the international arena through regional subsets of the Financial Stability Board, central bank grouping within the Bank for International Settlements (BIS), and the International Organisation of Securities Commissions (IOSCO) to help push implementation and enforcement according to global standards and to have regional input into global policy decisions.
In the last 12 years, the world has witnessed two major financial crises – one regional in Asia and the current global financial crisis. After the Asian crisis, the world saw a major revamp of the financial regulatory framework in terms of changing accounting, disclosure and regulatory standards and improving the surveillance process. It was clearly not enough. If the Asian financial crisis was the first demonstration that the Japanese bubble and deflation could have a massive impact on neighbouring markets, the current global crisis is a clear demonstration that financial fragilities in the west1 were truly global because of global interdependencies and externalities.
All financial crises are failures of markets and governance. The current global financial crisis is no exception. In the emerging markets, where financial markets are generally heavily regulated with government ownership, the crisis can be blamed largely on mistakes of governance at the corporate, regulatory and policy levels. In the developed financial markets, which are more mature, the regulatory philosophy hitherto has been that the market knows best, but the current crisis demonstrated that the existing policy and regulatory framework failed to prevent market excesses which brought massive damage not only to the financial sector, but also to the real economy. This crisis shattered many myths and preconceptions that well-regulated markets could be shielded from financial instability and that the fast-growing Asian economies could be decoupled from the developed western markets.
This article examines the current proposals for regulatory and policy reforms and considers the implications for Asia. Section 1 identifies the strengths and weaknesses of current Asian financial markets and how Asia is coping with the rapid changes in the regulatory environment. Section 2 reviews the current reform proposals. Section 3 uses a network framework to examine the current financial crisis and analyse the implications for financial reforms and global governance. Section 4 addresses the realistic options for Asian regulatory reform and the implications for regional and global cooperation in reforming the global financial architecture. The final section draws tentative conclusions.
1. The current financial and regulatory architecture in Asia
In the immediate aftermath of the 1997–99 Asian crisis, the world went through a thorough review of the global regulatory framework, with overhauls in regulatory standards. National regulatory structures were revamped with the creation of super-regulators (UK Financial Services Authority) or the twin peaks of prudential regulator plus conduct regulator along the lines of the Australian and Dutch models. The dot-com, Enron and Parmalat failures led to major reforms also in securities regulation, such as the Sarbanes-Oxley Act.
At the same time, given the phenomenal rise of derivative financial markets and the improvements in telecommunications and electronic trading, there was substantial deregulation of financial markets, with the removal of various market barriers, such as the repeal of the Glass-Steagall Act, the demutualisation of stock and derivative markets and dynamic growth of new players such as hedge funds, private equity and sovereign wealth funds. Overall, the volume of transactions increased exponentially, as transaction costs came down with rising leverage in an era of unprecedented low interest rates, large capital flows and high financial sector profits.
The 1997–98 Asian crisis left its legacy on the Asian financial system in several ways. In the first few years after the crisis, Asian banks began to consolidate and reform, but there was surprisingly little change in the direction of universal banking. Asia remained largely commercial-bank dominated and, given the trauma suffered by Asian regulators during the crisis, deregulation in capital markets was significantly slower than in western markets. Although some progress was achieved in promoting regional bond markets after the Asian crisis, these markets never reached the depth and liquidity of western markets, partly because the largest markets, such as India and China, were not yet fully open and partly because the pension and long-term fund markets were not yet fully developed. Equity markets, however, became significantly more active after the Asian crisis.
But with the exception of some advances in Korea and in the warrant market in Hong Kong, financial derivatives in Asia never quite took off. Indeed, the credit derivatives market was notably absent in Asia. This was partly due to the cautious attitude of Asian financial regulators towards derivatives, but also to the fact that Asian commercial banks rarely ventured far into universal banking and active securities trading.
The trauma that volatile capital flows wrought in bringing down strong Asian economies like South Korea also led to ‘self-insurance’ behaviour, with higher foreign exchange savings placed largely in western markets due to the inability of Asian capital markets to absorb the excess savings. The defects of the current global financial architecture, particularly the inability to coordinate global monetary and fiscal policies, created the conditions for the perfect storm.
Nevertheless, with the opening of markets after the Asian crisis and with the accession of China to the World Trade Organisation (WTO) in 2001, foreign bank entry into the Asian markets increased. Indeed, because of historical barriers against each other, Asian markets were more integrated and connected to US and European markets than with each other. For example, mutual funds registered in Luxembourg and bonds registered in Ireland were more freely traded in Asian markets than products registered within Asia. Moreover, due to their extensive branch networks throughout the region and superior skills, non-Asian banks and financial institutions were better integration facilitators than home-grown financial institutions. The number of Asian financial institutions with pan-Asian branches remains limited. For these reasons, capital market development within the region lagged behind western markets, and only a handful of Asian financial institutions became active players in investment banking outside their home bases.
Unlike the European Community, where there are political and economic reasons for regional integration, the Asian region remained relatively unintegrated except in the trade area, where the Asian global supply chain played a major role in networking component suppliers and services throughout East Asia. Reflecting this lack of strong regional financial integration, there was relatively loose regulatory cooperation within the Asian region.
In the central banking arena, there is a Bank of Japan-led body called the Executive Meeting of East Asia and Pacific central banks and monetary authorities (EMEAP), which tries to promote regional central banking cooperation. But this body excludes the South Asian central banks. In the securities area, the regional arm of the International Organisation of Securities Commissions (IOSCO), called the Asia Pacific Regional Committee, meets biannually. Regional insurance regulatory cooperation is relatively weak because the insurance business in Asia is dominated by state-owned or foreign insurers and is generally underdeveloped.
The lagged development of the Asian financial markets is reflected in their signal lack of influence in global regulatory discussions. Until India, China, Indonesia and South Korea were brought into global regional discussions via the G20 in 2008, the Asia-Pacific region was represented somewhat loosely in various international forums by the four leading financial markets, Japan, Australia, Hong Kong and Singapore. Until 2008, only Japan and Australia were represented on the Basel Committee, although Japan, Australia and Hong Kong were on the IOSCO Technical Committee. Singapore subsequently joined the other three in the Financial Stability Forum and these four meet biannually at the ministry of finance/central bank deputies level in what is known as the Four Markets Meeting. This meeting has been more useful in terms of exchange of information and views than in forming a caucus for lobbying.
The level of influence in international forums depends not just on economic weight but also on the state of research and policy analysis at the government, think tank, academia and industry levels. Australia has performed well because of its sophisticated financial markets and well-developed policy research institutions. The famous Campbell and Wallis Committees on financial sector development and reform initiatives have had a major impact on Asian thinking and through the twin peaks idea promoted in the Wallis Report (1997), some impact on global regulatory structure discussions. Singapore punches significantly above its financial weight because of well-planned diplomatic lobbying and use of policy think tanks to debate issues thoroughly with key stakeholders.
Despite the fact that Japan has been a member of the Basel Committee on Banking Supervision and provided staff for and exchanges with the Bank for International Settlements (BIS), IOSCO and the International Association of Insurance Supervisors (IAIS), the amount of influence that Japan could bring to bear on global regulatory discussions was limited. This could be attributed partly to the fact that, for a while, Japan was the lone Asian voice, while its relative economic and financial position had receded with the long years of economic deflation. However, part of the reason is also due to the fact that Japan’s positions on many issues were taken from the perspective of complex domestic consensus building within Japan and therefore may not have taken into consideration the views of the emerging markets.
Most Asian financial regulators were caught unawares by the ferocity and scale of damage caused by the global crisis, even though their own markets were initially cushioned from the early shocks due to strong domestic economic growth and rising prosperity. After all, when the European and US central banks had to intervene significantly in August 2007 to provide liquidity to their commercial banks, Asian banks were hardly affected by the subprime shocks. But the real sector shocks through the sharp declines in exports, rise in unemployment and then sharper deflation in the asset markets were significant.
What was more shocking to Asian financial regulators was the irony that the ‘complete’, mature and sophisticated financial markets and regulatory systems that they were emulating had imploded before their eyes. What they thought were best practices turned out to be fragile behaviour that could not withstand the shocks from the collapse of the wholesale securitisation funding market.
The network architecture of Asian financial markets should be understood before we discuss its regulatory framework. Firstly, there is no single Asian political or economic entity, but rather at least five distinct zones that have very different histories, cultures and levels of financial development – North Asia comprising the economies of Japan, Korea, China, Taiwan and Hong Kong; Southeast Asia (ASEAN); South Asia; the oil-producing countries of the Gulf and Middle East and central Asia; and also, loosely within the Asia-Pacific sphere, Australasia. Asian financial market skills are concentrated in Japan, Australia, Hong Kong and Singapore, with rising depth in India, China and the Gulf as wealth and economic power have attracted financial talent.
Secondly, in terms of historical and financial trading ties, each zone is networked more with London and New York than with others. This is partly due to the fact that financial market skills are concentrated in these two centres. An additional factor is that they are major trading hubs for the dollar and the euro, with superior comparative advantage in terms of depth, breadth and liquidity of their financial markets.
A third distinctive feature of the Asian financial structure is the strong role of the state. As Charles Goodhart has suggested in his stylised comparison between the Asian and Anglo-Saxon models, the Asian variety has a sizeable proportion of the financial system under public sector ownership and/or control. This implies much greater direct influence of the public sector, especially the ministry of finance, central bank or financial regulators (Goodhart, 2009). Since Asian society is more consensual and pragmatic, its bureaucrats have greater ‘ownership’ of financial stability, meaning that the elite understand that they will be held directly responsible for social stability.
Turf fighting and jurisdictional jealousies are common to all regulators, within Asia or otherwise, but in less sophisticated systems, where regulatory power has been concentrated in either central banks or functional regulators, Asian regulators have been more willing to experiment with non-orthodox instruments to protect their financial systems, such as lowering loan-to-valuation ratios, increasing margins, quantitative credit restrictions and even direct market intervention to preserve market integrity. Having large state-owned stakes in the financial system means that regulators are less ideologically inclined to trust market forces under conditions of extreme stress.
Hence, Asian policy makers tend to be willing to be bold on the asset/real sector side, but generally quite conservative on the liability (fiscal and financial) side of the national balance sheet. After the Asian and Japanese crises revealed the dangers of overleveraging in the corporate sector, Asian policy makers have erred on the ‘self-insurance’ side, and have been cautious about the risks of welcoming too many hot money inflows. Due to higher savings, Asian economies as a whole are not highly leveraged, especially after the Asian crisis.
A fourth feature is the dualistic nature of Asian economies, with fairly strong export-oriented manufacturing sectors and relatively weak service sectors. Reflecting this dualism, many Asian financial institutions are not geared to serve the needs of a vast range of smaller and disadvantaged clients, which may have led to social disparities at sectoral and regional levels. The result is that the external sector and large state-owned enterprises and urban corporations have easier access to bank credit than the rural areas and small and medium enterprises (SMEs).
The 1997–98 Asian crisis exposed severe weaknesses in corporate governance, risk management and bank supervision, so in the last decade Asian banks have considerably upgraded their risk management skills by strengthening capital and consolidating through merging or acquisition (Turner, 2006). Significant efforts were put into upgrading bank and regulatory supervisory capacity, with diligent efforts at implementing Basel, IOSCO, IAIS and International Accounting (IAS) standards. But so far, Asia as a region lags behind other regions in having Financial Sector Assessment Programmes (FSAP) assessments. India, China and several other Asian markets have agreed to such assessments in the near future.
Fifthly, the Asian financial system also reflected the different development strategies adopted at the industrial level. By and large, commercial banks made profits from lending to finance exports and manufacturing, as well as residential mortgages. Only as the middle class grew in size did domestic banks move towards consumer financing. Capital market development has been constrained by the lack of institutional investors, particularly retirement and social security funds. As the populations begin to age, such institutional investments will naturally grow in size and help the development of capital markets.
However, Asian financial institutions are now in a state of shock. Universal banks like UBS and Citibank have stumbled, causing a major rethink. Asian financial regulators were relieved that the delay in opening up the capital accounts in India and China helped cushion their banking systems from direct shocks, but are less clear now where to focus their reform efforts.
Some directions are relatively clear. As Asian economies try to reduce their excessive reliance on exports, the demand for funding, both from the banks and capital markets, will move towards infrastructure, domestic industrial restructuring, consumer financing and also SME funding. Some innovative banks are discovering that they can benefit from superior quality customer service, without being wholly reliant on declining bank spreads and sheer volume of growth. Others may find that rural banking might not be as unprofitable as the conventional wisdom suggests.
A second strategic move is outward expansion of the financial network through branching out abroad, but it is unlikely that the frenetic branching out of Japanese and Korean banks into regional and global financial centres in their early phase of liberalisation will be repeated. Asian banks have become much more prudent and discriminatory in the choice of their new target markets, looking more at neighbouring countries and areas of competitive advantage.
In short, Asian financial regulators have modelled (somewhat lagged) their regulatory structures along the lines of mainly Anglo-Saxon models of the combination of offsite surveillance and onsite surveillance. The restructuring of the regulatory framework has only occurred in the more advanced markets, such as Australia (twin peaks), Japan, Korea and Singapore (super-regulator), whereas the others are still largely in the fragmented institution-based regulation mode.
Given the uncertainties of the global economic environment, we therefore have to examine the future direction of regulatory policy and practices in Europe and the US before we can comment on Asian regulatory policy and attitudes towards regional and global cooperation.
2. Global regulatory reform efforts: a network perspective
There is already much financial regulatory reform under way. The EU has taken a series of important measures, including a supervisory framework reform composed of two new pillars: a European Systemic Risk Council (ESRC) and a European System of Financial Supervisors (ESFS). In the US, the Treasury has proposed more federal regulatory oversight of the financial sector, with the creation of a systemic risk council (upgrading the President’s Working Group on Financial Markets) and a consumer financial products safety commission. There are plans to provide the government with the tools to manage the orderly exit of failed financial institutions through widening the powers of the Federal Deposit Insurance Corporation (FDIC). Plans are also afoot to put clearing of financial derivatives on to exchanges, regulating management compensation and also regulation of hedge funds.
In the UK, the Treasury reforms call for more effective prudential regulation and supervision of firms, greater emphasis on monitoring and managing system-wide risks, more action on management of the particular problems posed by ‘high-impact’ firms and greater protection for the taxpayer. Many of the reforms are enacted in the UK Banking Act 2009 and UK Financial Services Bill 2010.
Since the collapse of Lehman Brothers, there has also been a flurry of major studies on the crisis, recommendations and also national proposals for regulatory reform. These include the G30, the Geneva, de Larosière and the UN (Stiglitz) Reports.2 At the national or regional level, the US Treasury, the European Commission and the UK have also issued major consultation reports for reform that are under varying stages of legislative approval. Although the common elements are the need to develop a system-wide view and the desire to strengthen the powers of financial regulation, its scope to cover all systemically important activities and ability to resolve failed financial institutions, the most controversial parts of the reform proposals are really about the power of ‘who does what?’
The jurisdictional debate in the US is illuminating. One regulator is already openly lobbying against giving the Fed the power to become the single systemic regulator. The possibility of merging the Commodities and Futures Trading Commission (which regulates commodities derivatives) and the Securities and Exchange Commission (which regulates financial derivatives) has already been ruled out due to the inability of different Congressional Committees to unify their scope of jurisdiction. The only agency that could still be eliminated in the restructuring is the Office of Thrift Supervision (OTS), which may be merged with the Office of the Comptroller of the Currency (OCC), both being under the Treasury Department.
The Chicago professor, Richard Posner, who made his reputation on the law and economics of regulatory capture, thought that the US Treasury’s proposals for regulatory reform were ‘premature’, because ‘it advocates a specific course of treatment for a disease the cause or causes of which have not been determined’ (Posner, 2009). Among the causes omitted include the errors of monetary policy, large annual fiscal deficits, deregulation movement in the banking industry, ‘regulators were asleep at the switch’ and ‘complacency of and errors by the economics profession’. In other words, prognosis came before diagnosis.
Posner also thought that:
plans for reorganizations are cheap and visible, and plans are the easy part; it is at the stage of implementation that government falls down … the reorganization usually fails, because of inertia, turf warfare, passive resistance and lack of follow through, leaving in its wake more bureaucracy.
Even though Posner was critiquing the US reform proposals, he may have identified problems common to many of the global reform efforts. One of the key reasons why few financial regulators and economists saw the full implications of the financial crisis as a systemic crisis was because of what University of California physicist and system scientist Fritjof Capra (1982, p. 6) called ‘the fragmented methodology characteristic of our academic disciplines and government agencies’. The academic disciplines and regulatory agencies have become so specialised and narrow in their training and perspectives that they can only see partial problems and partial solutions, without understanding that current problems are systemic problems that are highly interconnected, interdependent and interactive. Often, departmental pride and self-interest came before the overall public interest.
This is particularly true for banking, which has become universal in product range and global in scope, but is regulated ineffectively in national segments often characterised by gaps, overlaps or even inertia and regulatory capture. Governor of the Bank of England, Mervyn King, summarised this with the comment that global banking is global in life but local in death.
The political economy of giant global complex financial institutions being regulated by dwarfed national economies or by fragmented agencies has created a situation of a regulatory ‘race to the bottom’, whereby no single regulator dares to be too tough for fear of losing business abroad. The too big to fail and too interconnected to fail syndrome has created a hostage situation whereby national governments are forced to rescue these institutions with taxpayer money. In a classic case of bad principal–agent problem, bank management has managed to lose money both for shareholders and for taxpayers but still retain salaries and benefits higher than non-financial jobs.
Increasingly, there is awareness that the financial system has created large and hidden leverage that is systemically fragile in a case of bad incentives encouraged by the moral hazard of deposit insurance. There is a current debate in the UK and Europe over whether banks have become too big and therefore should be cut in size. Recently, the debate has been over whether the reduction in size should be due to higher capital, deleveraging or using instruments such as Tobin taxes to reduce bank profitability.
The reality is that global finance has become a collective action trap, whereby the interests of the large complex financial institutions and their home and host regulators are divergent, with different legal rules, technological platforms and huge information asymmetries making coordination of interests unlikely. Finance has become global in product range and scope, but is regulated ineffectively in national segments. This is a global tragedy of the commons, in which host regulators on their own are too small to influence the behaviour of large complex financial institutions, while home regulators may not see the systemic risks building up outside their jurisdictions.3
The lack of cooperation between host and home regulators creates massive problems of early detection, preventive action, crisis management and insolvency resolution at the information sharing and effective action level. Many of the problems of coordination are surveyed by Evanoff et al. (2007), especially the problems of cross-border resolution of large failed banks.4 The proposed solutions of supervisory colleges, moving towards a common insolvency regime for failed global banks, living wills, etc. do not deal satisfactorily with the problem of mistrust and conflicting interests between home and host regulators, resulting in a lack of quick effective action that is needed at the prevention and resolution levels. Asian regulators are leaning towards the New Zealand solution of requiring foreign banks to incorporate their subsidiaries in their local operations.
One way to put some of the issues into a system-wide perspective is to view the global financial market as a system of national networks, with the current global crisis being a network crisis (see Haldane, 2009; Sheng, 2009). First, the network framework requires the policy maker and financial regulator to have a system-wide view of the ‘ecosystem’ of financial markets, which means that one must examine their network architecture and fragility or vulnerability to crises. If financial markets are global, the present regulatory structure is fragmented into national jurisdictions and compartmentalised into domestic silos of regulation on an institutional basis, rather than a functional and network-wide basis. This implies that, all too often, national financial regulators do not have jurisdiction or perspective on what is really happening to these global complex financial institutions that they are supposed to regulate.
Secondly, the increasing complexity of networks is related to their fragility and also positively correlated with the highly asymmetric information and externalities of network behaviour. Present models of risk management measure risks that are known but mostly ignored long-tail Black Swan risk and non-measured externalities. Clearly, boards, management and financial regulators did not understand the systemic risks of holding and trading such complex products.
Thirdly, the high degree of interconnectivity led to the growing concentration of activities in key hubs and large, complex financial institutions which dominate global financial trade and have become ‘too big’ or ‘too connected to fail’. Interconnectivity was the channel through which contagion was transmitted.
Fourthly, networks have negative and positive feedback mechanisms due to the interactivity between players and between hubs and nodes as they compete. The market players have been ‘gaming’ the system using standards and rules that are procyclical.
Fifthly, distorted incentives structures such as management compensation promoted risk taking at huge moral hazard levels.
Sixthly, policy makers and financial regulators did not act countercyclically. Much of this inactivity was blamed on rules or codes that embed procyclicality, but no one paid sufficient attention until it was too late.
Finally, the allocation of roles and responsibilities within network governance between home and host regulators is complex and has not proved effective. No single regulator has full control of the whole network or even a single institutional network. International regulatory cooperation still operates under Westphalian rules, in which no country has jurisdiction across national borders because there is no global treaty to sort out disputes between different regulators and to enforce cooperation. Currently, international regulatory cooperation is achieved through Memoranda of Understanding that have no legal standing. Even the proposed college of supervisors may not work because of difficulties in sharing highly market-sensitive information and lack of trust between regulators.
In contrast, the World Trade Organisation works on a treaty basis between all members, where rules can be enforced through an arbitration and sanction basis. This is possible because there is global consensus that free trade is beneficial for all. There is no global consensus on whether financial flows have the same benefits, because many emerging markets still suspect that free portfolio capital flows could be destabilising for small economies. Unfortunately, effective enforcement of regulation across a global network requires complex and binding cooperation between different regulators.
The network analysis views the global financial structure as a complex, evolutionary system of local networks, and currently prone to financial instability due to volatile capital flows arising from structural imbalances and policy errors. Although there is a shift in the balance of economic power from the rich to the large emerging countries such as China and India, the basic rules of the game have not changed.
3. Implications for reforming the current global financial architecture
If we accept the analysis that the current crisis is a network crisis, then it may very well be that the current reforms are premature. There is a real risk that many of the proposed reforms may have added complexity to an already complex and perhaps seriously flawed situation and may not have addressed the fundamental issues. We may need to go back to basics and look at how the system could be restructured to fit the new global realities.
Firstly, if we agree that the real sector problem (the global imbalance) is due to excess consumption financed by excess leverage, then in the medium term the financial sector would have to deleverage back to a more sustainable level. This deleveraging will have a procyclical impact on real sector activities. This is currently being offset by massive fiscal expenditure, the quality of which is subject to debate. If fiscal expenditures are concentrated into rescue of failed institutions that are still ‘leverage machines’, nontradables and nonefficient infrastructure, then in the long run global growth will still be slow, despite the short-term stimulus.
Secondly, if, on the other hand, the policy direction to create a more ecological and financially sustainable global economy prevails, then the restructuring towards a more green economy, with higher energy saving, product recycling, ecologically friendly and less resource-intensive production may have a very unpredictable impact on the profitability and risks for the financial sector. Excess capacity in the Asian global supply chain will have to be unwound as production shifts from exports towards domestic consumption as an engine of growth, and as individual countries close down sunset industries that are polluting and energy inefficient. This implies that, over time, Asia will have to strengthen its capital markets significantly relative to the banking system.
Thirdly, we have to recognise that financial stability is affected not just by issues directly related to the financial sector, but also by real sector fragilities, such as natural disasters, terrorist action, civil unrest and war. Hence, global cooperation over financial stability cannot be independent from other areas of global governance.
Fourthly, there is still a huge gap between the developed mature financial markets and the emerging markets in depth of skills, knowledge and comprehension of financial stability issues. This is a gap that developed market specialists tend to forget as they evolve more and more complex rules and regulations suitable for their conditions and challenges. This gap arose partly because of a legacy legitimacy issue – the limited representation of the emerging markets at the international regulatory standard bodies to reflect their needs and priorities.
For example, the Basel II core principles are very complex and expensive to implement for emerging market banks. There are severe gaps in the regulations on liquidity and the general focus on capital adequacy until recently was on ‘capital efficiency’, which meant that global banks could use sophisticated internal-risk-based (IRB) models to estimate risks and therefore capital adequacy. As the current crisis uncovered, many of the banks did not have adequate data time series to calculate risks in stressed situations and the Value at Risk (VaR) models were defective in accounting for tail risks in extreme market conditions. It is by no means clear (and evidentially not proven) that implementing Basel II would make emerging market banks safer than simpler enforcement of key risk levers and changes in corporate governance.
Fifthly, on top of the ‘understanding gap’ there is another ‘implementation gap’, because many emerging markets have not yet implemented in depth the international regulatory standards, partly because of a lack of sophistication, a shortage of human skills and, more importantly, the lack of applicability of these standards to emerging market conditions. It should be noted that the Basel Committee on Banking Supervision has no enforcement or implementation capacity, since it is a pure standard-setting body. The Bretton Woods institutions and some aid agencies provide limited technical assistance, but many emerging market regulators see little priority to implement such standards rigorously unless an FSAP is imminently pending.
What, then, are the implications for global governance and the financial architecture? To begin with, we must accept that there can be no ‘one size fits all’ approach for financial regulation, reform, crisis prevention or resolution. Hence, the realistic approach is to engage those markets that are likely to have systemic implications for global financial stability.
Since current regulatory standards and structures are still under controversial debate in the sophisticated markets, it is unrealistic to expect that emerging markets would agree to adopt even more complex standards and rules that would be hugely resource intensive, without clear evidence that these reforms would solve many of the existing problems. At most, we can arrive both at general principles and at a general approach to the rules and regulations. Through network analysis, we need a system-wide view of system vulnerability and structural issues with a good appreciation of where the weakest links and risk concentrations lie.
Secondly, financial regulators should address the issue of complexity. In other words, rules and regulations should be simple to understand, simple to use and implement and facilitate enforcement and accountability.5 For emerging markets, it means using a few clear and simple rules, firmly enforced.
Thirdly, network reforms should divide the systems into modules, with relevant firewalls and risk controls, so that reforms can be achieved on a modular basis (Beinhocker, 2006). The financial market, like a network, can be divided and built on a modular basis, so that the modular components can be ‘isolated’ in the event of huge shocks. The most drastic example of ‘isolation’ is exchange control, but putting derivative markets into central clearing is one way to ensure that the risks can be contained.
Fourthly, the issue of interactivity or feedback mechanisms should be addressed by removing the procyclical bias in current standards and rules.
Fifthly, for each economy, and on a global level, there must be limits of overall leverage, which should be identified and strictly enforced, such as the Maastricht criteria on current account and fiscal deficits.
For global governance to be effective, the organisational structure must satisfy the four operational and participatory gaps identified by Benner, Reinicke and Witte (2004, p. 193). The operational gaps are: the jurisdictional gap between global public goods (and needs) and disexternalities that extend beyond the legal powers of nation states; the temporal gap between the need for timely action and long-term intergenerational sustainability solutions; the complexity of public policy issues that have profound economic, ecological, political and security effects on a cross-border basis; and the contradiction between market-reinforcing agreements (e.g. WTO) that concentrate power versus equitable standards, such as human rights, environmental and labour issues. The participatory gaps exist in the areas of growing income and wealth inequality arising from globalisation; and also the legitimacy issue, particularly from civil society, such as NGOs, which demand to be heard on global issues.
The reality of the current global architecture is that it is dominated by clubs but shaped by contests of changing but interdependent power structures. Hence, with difficulty in getting consensus, there is likely to be a lot of muddling through.
4. How should Asia fit into the global regulatory architecture?
It is useful to remember that ‘structure follows strategy’. The current global financial structure has followed Pax Americana, with the United States as the largest dominant military and economic power. Bretton Woods 1 was designed for an era of dollar shortages, fixed exchange rates and largely protectionist markets, so that International Monetary Fund (IMF)/World Bank credit was provided in exchange for opening up markets to free trade and democracy. Bretton Woods 2 opened up to an era of flexible exchange rates and depegging from gold, but was found to be unsustainable given high volatility of capital flows and asset bubbles.
There is considerable debate about whether the world should have a single super-regulator to manage global financial stability, but the G20 London Summit on 2 April 2009 did not accept that model. The only serious effort to change the financial stability architecture was to upgrade the Financial Stability Forum (FSF) into a new Financial Stability Board (FSB), with the additional membership of Spain and the European Commission. It did not change the fundamental reality that remedies for the global slump, whether in the form of fiscal stimulus or comprehensive plans to clean up banks, remain essentially national, not global. Even the voting structure of the Bretton Woods institutions was only minimally changed.
Professor Robert Wade of the LSE, an astute critic of the international architecture, has argued that the G20 has in fact reinforced the Anglo-Saxon ‘standards-surveillance-compliance system’ (Wade, 2007). Since the dominant central banks will not allow the IMF to be either a global central bank or lender of last resort (Taylor, 2007), the Westphalian principle still applies. There will be no global enforcer of hard rules, only ‘soft’ surveillance plus peer pressure. In other words, we have to live with the reality that unless the social losses are traumatic, the status quo will only change incrementally, not radically.
The above assessment suggests that globalisation would require Asia to take a stance on how to develop itself. It is clear that Asia needs to build a strong and solid financial base, both at home and regionally, before better integration into the global financial network. It was precisely Asia’s lack of developed capital markets that led to the flow of excess savings to the west, inviting criticism of causing the global imbalance. Since large parts of Asia lack social infrastructure, excess savings can be channelled within Asia to fulfil such needs through more efficient capital markets.
Thankfully, there is recognition that even though unregulated innovation was at the heart of the current crisis, we cannot conclude simply that all financial innovation is bad. In my view, the Asian system will have to ‘invent’ its own form of innovation, not in more complex derivative or leveraged products, but in the sense of using technology to deliver better customer services. Because Asian financial development is, to a very large extent, at the Glass-Steagall stage, Asian regulators and policy makers need to figure out how to make their markets evolve from the traditional retail banking model to the new wholesale one with market-based credit. Considering the skills and technology constraints, this will surely take time to achieve.
Second, the failure of growth for growth’s sake and relentless expansion of universal banking through leverage has led to a rethinking of the ‘too connected and too big to fail’ problem. Asia needs to learn that at the end of the day, the development of banks cannot be built on scale and leverage, but only on the enhancement of quality. Whether the financial system will play its major role of efficient resource allocation of capital will depend on the financial system’s structure and incentive structure. This is where financial policy and regulatory enforcement play a huge role. If the perimeter of leverage and irresponsible behaviour is not patrolled and enforced rigorously, then Asia could face another round of asset bubbles and financial crises.
The debate over how to divide the ‘too big to fail’ has been controversial, but hinges on a fundamental point of whether banks should be agents for public savings or principals trading on their own account. Most laymen would support retail commercial banks as utilities that have to have deposit insurance and central bank lender of last resort facilities to protect the public good. However, the fact that banks are now trading on their own account vigorously for their own profits means that there is now an unlevel playing field between banks as principals with huge state subsidies in terms of implicit guarantee and other principal traders such as retail or even fund managers.
If we believe in free markets with level playing fields, this would require banks to separate their proprietary trading, which usually carries higher risks and conflicts of interest, out of their utilities roles.
If we accept that the world is a diverse ecosystem, then for sustainable and stable growth we must have eco-diversity. This implies that even though there are universal principles, it may not be healthy to have universal rules and standards that ultimately enforce monoculture and uniform behaviour, which bring their own concentration risks, rigidities and herd-like behaviour. Financial markets thrive on different types of institution with different behaviours, dealing with risks through diversity. Asian financial regulators will have to allow more small-scale financial institutions to survive and enter the system, in order to ensure diversity. Diversity means also that we must accept risk and the creation of boutique risk institutions, with greater private sector ownership. All this will take time, because what are lacking are not financial resources but human skills.
At the regional level, the restructuring of the Asian global supply chain export model to a more domestic demand driven one will require Asia to conduct greater monetary cooperation, not ruling out a regional currency arrangement. The reason is that competitive devaluation regionally would lead to a race to the bottom. A lot of structural reform in each country will have to take place. In doing so, Asia will have to accelerate the programme of building high-quality, high-transparency regional markets to finance all the social infrastructure and environmental adjustments that Asia needs. Those markets that take the opportunity to strengthen their domestic financial systems, improve domestic corporate governance, develop their social infrastructure and maintain social stability will be the major winners.
Asia is unlikely to move towards closed regionalism, but open regionalism with continued strong links to Europe and America. Regional cooperation is important because the Asian economies share common problems of lack of human skills and lower levels of financial development and could therefore pool resources and experiences in implementation. Specifically, greater internal debate and policy discussions can only strengthen Asian influence in global policy formulation.
Implications for the Asian financial regulatory structure
The shaping of the business model and financial markets will have considerable influence on the Asian financial regulatory structure. Three trends are discernible. First, different Asian jurisdictions will adopt either the super-regulator or the twin peaks model, depending on their own national conditions. However, the difficulties of effective coordination between the central bank, the ministry of finance and the super-regulator remain, as the UK experience has demonstrated. The crux of the current problem is that, operationally, work and authority are delineated more or less across different agencies of the government, whereas financial market activity and externalities know no legal or operational boundaries. Hence, although we can say that there is ultimate accountability at the political level, it is not so clear at the operational and departmental level.
We can safely predict that given the hard lessons of the Asian crisis, Asian financial regulation will remain conservative and prudent, with greater emphasis in future on enforcement of relatively simple rules that match the simpler market conditions. As markets become more integrated and sophisticated, there will be greater convergence of different regulatory philosophy, tools and measures, but there will not be harmonisation of standards and structure along the European model.
The biggest challenge within Asia is not the lack of rules, but the lack of effective implementation of the Basel, IOSCO and insurance principles. Like the proposed set of simpler IAS set of accounts that fit SMEs, one of the issues under debate will be whether there should be a simpler version of the core regulatory standards where there is some guidance on what takes priority for emerging markets.
Second, infrastructure and also enforcement capacity need to be enhanced so that there is greater compliance and concerns over systemic stability. Asia needs a system-wide view of financial stability, both at the national and regional levels. A domestic financial stability forum will help engage multi-stakeholder ownership and enhance implementation of risk management capacity. In other words, a strong global network must begin with strong and resilient domestic networks. Regionally active FSB, BIS and IOSCO types of institution will act as the building blocks for stronger global architecture. Specifically, regional arrangements will strengthen regional cooperation, support deliberations of the FSF at the global level and motivate training and implementation at the local level.
The present FSB structure is essentially a talking shop with influence over some regulators and standard setters, but little implementation capacity, since these are delegated to the Bretton Woods institutions and the standard setters. Active participation in regional and global forums will place a heavy onus on Asian regulators, both in terms of commitment to developing international regulatory standards, and also expectations in terms of openness, transparency and communication with other regulators. Regional meetings of IOSCO, Basel Committee or FSB members can coordinate and filter views and experience on the ground either directly to the FSB or indirectly through their leading FSB members.
The institutionalisation of Asian regional and global cooperation will be challenging, given that it is a geographically vast, culturally diverse, economically disparate and politically complex region. Nevertheless, there is increasing awareness that many of the problems that Asia and individual economies face cannot be solved by national action alone. The interdependence and interconnectivity are such that there must be greater dialogue and policy research. Given the disparate levels of financial development and understanding of the issues, convergence towards global standards will inevitably take time.
At the Davos meeting on 27 January 2009, Forum chairman Klaus Schwab argued that ‘What we are currently experiencing with the financial crisis and its consequences is the birth of a new era – a wake-up call to overhaul our institutions, our systems and, above all, our thinking’.
If complex networks cannot be disentangled or repaired overnight, even at the national level, then it is quite realistic to assume that the global financial architecture will not reform quickly or voluntarily. It will evolve from competition within the system. The net conclusion is that there is unlikely to be a ‘Big Bang’ in financial sector reforms, even as the current financial crisis evolves, until there is much better understanding of the causes and characteristics of the change in the ecology of financial markets. However, within Asia there is a gradual realisation that its financial markets must change rapidly in response to fundamental changes in demographics, consumer behaviour and industrial structure. How these will impact on the regulatory architecture will be an interactive debate between Asia and the rest of the world.
The views expressed are personal to the author and do not represent the views of the CBRC or any institution he is associated with. The author is grateful to Zhang Jingchun of the CBRC and Wang Ting for research assistance.
The term ‘west’ covers the EU and the US. Japan is included within Asia, which is defined as the IMF statistical coverage of countries included within the Asian region.
These include: Group of Thirty Report on Financial Reform (2009); Geneva Report No. 11 (Brunnermeier et al., 2009); the de Larosière Report on Financial Supervision (2009); the Turner Report (2009); and UN Commission of Experts (Stiglitz Report) on Reforms in International Monetary and Finance Systems (2009).
See Ostrom (1998) for the political economy of resolving tragedies of the commons.
See particularly the papers by Krimminger, Lastra and Murton in Evanoff (2007). I am grateful to an anonymous referee for pointing out these references.
This is a perennial struggle between financial regulators and the financial institutions, which prefer rule-based clarity, requiring numerous exemptions, safe harbours and caveats that make the rules more complex, often impossible for the layman to comprehend. Legal exactitude prevails over common sense.
Andrew Sheng, Chief Adviser, China Banking Regulatory Commission.