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The Debate on Financial
Regulation: Some Lessons for Asia
Asian specificity
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Asian emerging markets are seen as having
displayed a degree of resilience and an element
of robustness in the aftermath of the financial
crisis.
The crisis is not seen as Asian because financial
regulation prevented exposure to toxic assets
and because of the recapitalization of the
banking sector after the Asian crisis.
Often taken to mean that the debate on reregulation is not of much relevance to them.
Ignores financial liberalization
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Financial liberalization has been implemented
by all developing countries, and though done
to differing degrees is as a tendency that is
very similar in all.
All these countries are moving or have
moved to a Basel-type regulatory framework,
which implicitly involves reduced structural
regulation and regulatory forbearance.
Replication of the Anglo-Saxon model of the
1980s and beyond.
Financial expansion and external
liberalization
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Ever since the 1970s, attempts by financial
firms to evade domestic regulation has
involved global spread, which had developing
countries as counterparties.
Developing countries themselves attempted
to use this “opportunity” to deal with balanceof-payments constraints by changing rules
with regard to cross-border capital flows and
exchange rate determination.
Need for structural liberalization: 1
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If liberalization is to be successful in
attracting international liquidity it becomes
necessary to allow entry of the carriers of
capital.
Done in the name of enhancing competition
by easing entry—but involves permitting
acquisitions as well, leading often to
concentration rather than increased
competition.
Need for structural liberalization: 2
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With entry of the carriers of capital, demands
for changes in the financial environment and
regulatory framework to correspond to those
in the parent countries increases.
Increasingly the structure of markets,
institutions and instruments are reshaped to
replicate the imported “model”.
Dismantles the specific financial structures in
these countries to generate less regulated
markets.
What does this do?
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In the developed countries the crisis has
challenged mainstream perceptions on the
functioning of financial markets and the
efficacy of regulatory regimes
Has reform created new vulnerabilities in
developing countries as well?
Impact of dependence on capital flows
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Integration had increased capital inflows in
the form of direct investment, portfolio capital
and debt well before the 1997 crisis.
The decline after the crisis was quickly
reversed and we had a capital surge since
2003.
Capital flows to developing countries
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Net external financing flows which had fallen
from $360.1 billion in 1997 to $173.5 billion in
2002, have since risen sharply to $785.5
billion in 2006.
While foreign direct and portfolio investment
increased from $153.8 billion in 2002 to
$446.7 billion in 2006, net external borrowing
rose from $10.9 billion in 2001 to 294.5 billion
in 2006.
Capital flows to developing countries
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Total flows touched a record $571 billion n 2006,
having risen by 19 per cent on top of an average
growth of 40 per cent during the three previous
years. Relative to the GDP of these countries, total
flows, at 5.1 per cent, are at levels they touched at
the time of the East Asian financial crisis in 1997.
Private debt and equity inflows, which had risen by
50 per cent a year over the three years ending
2005, increased a further 17 per cent in 2006 to
touch a record $647 billion.
Is this process benign.
Revival of the credit spiral
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Net private debt and equity flows to developing
countries had risen from a little less that $170 billion
in 2002 to close to $647 billion in 2006, an almost
four-fold increase over a four-year period.
Net private equity flows, which rose from $163 billion
to $419 billion, dominated the surge, but net private
debt flows too increased rapidly. Bond issues rose
from $10.4 billion to $49.3 billion and borrowing from
international banks from $2.3 billion to a huge
$112.2 billion.
Net short-term debt, has risen from around half a
billion in 2002 to $72 billion in 2006.
Foreign bank presence
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At the time of the East Asian crisis (mid1997), the international asset position of
banks resident in 23 countries reporting to
the Bank of International Settlements stood at
$8.6 trillion after adjusting for local assets in
international currencies. By June 2007, when
40 countries were reporting, this had risen to
$29.98 trillion.
The supply-side scenario 2
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Non-bank financial firms—pension funds, insurance
companies and mutual funds—had emerged as
important intermediaries.
The total financial assets of institutional investors
stood at $46 trillion in 2005. Of this, insurance firms
accounted for close to $17 trillion, pension funds for
$12.8 trillion and mutual funds for $16.2 trillion.
The US dominated here with $21.8 trillion of
institutional investors’ assets. UK $4 trillion.
Total assets more than doubled between 1995 and
2005 from $10.5 trillion in the US and $1.8 trillion in
the case of the UK.
New markets and instruments
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In 1992, the daily volume of foreign exchange
transactions in international financial markets stood
at $820 billion, compared to the annual world
merchandise exports of $3.8 trillion or a daily value
of world merchandise trade of $10.3 billion.
2004 Triennial Survey of Foreign Exchange and
Derivatives Market Activity shows: the average daily
turnover (adjusted) in foreign exchange markets
stood at $1.9 trillion.
About 2 per cent relative to real economic activity
across the globe. But in 2003, the value of world
merchandise exports was only $7.3 trillion.
Trade in derivatives
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Average daily volume of exchange traded
derivatives amounted to $4.5 trillion in 2004. In the
OTC derivatives market, average daily turnover
amounted to $1.2 trillion at current exchange rates.
Thus total derivatives trading stood at $5.7 trillion a
day, which together with the $1.9 trillion daily
turnover in foreign exchange market adds up to $7.6
trillion. This exceeds the annual value of global
merchandise exports in 2003.
Other signs of systemic risk
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Ten countries (out of 135) accounted for 60 per cent
of all borrowing during 2002-04, and that proportion
has risen subsequently to touch three-fourths in
2006.
In the portfolio equity market, flows to developing
countries were directed at acquiring a share in
equity either through the secondary market or by
buying into initial public offers. IPOs dominated in
2006, accounting for $53 billion of the $96 billion
inflow. But here too there were signs of
concentration.
Concentration in flows
Share of “Top Seven” in Asian emerging market external financing
2004 2005 2006 2007 2008 Q1 08
China
16.8 20.5 22.6 25.2 15.8 19.5
Hong Kong
12.7 10.6 11.6 7.9 8.4 4.3
India
8.7
11.4 13.3 19.6 20.2 25.7
Indonesia
2.7
2.7 3.8 2.7 7.5 6.6
Korea
20.4 25.2 17.4 20.1 18.6 19.4
Singapore
7.8
7.7 8.9 6.6 11.1 9.8
Taiwan
17.4 10.1 10.0 8.2 9.8 10.5
Total
86.6 88.1 87.6 90.4 91.3 95.7
Source: www.bis.org
Q2 08
15.1
8.9
14.8
10.9
25.7
11.7
5.6
92.8
Q3 08
15.9
14.1
18.3
3.5
10.1
13.9
11.2
86.9
Q4 08
7.5
6.4
22.6
9.4
16.0
7.6
15.2
84.8
Expected vulnerability
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Capital reversal in times of crisis because of need to
sell assets to meet payments commitments or cover
losses in the developed countries
For example, over the year ending January 2009,
the Reserve Bank of India estimates that the net
outflow of FII capital amounted to $23.7 billion.
Large when seen in relation to the estimate made by
the RBI that the total stock of inward investment in
equity securities stood at 103.8 billion at the end of
December 2007. That stock had fallen to $80 billion
by the end of September 2008.
Impact on stock markets
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One consequence of capital outflow was a
collapse of India’s stock markets, because
capital inflow had earlier triggered a
speculative bubble in both stock and real
estate markets.
Instability in stock and currency markets led
by FII investments.
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Axis Title
Sensex and Cumulative FII
70000
25000
60000
20000
50000
40000
15000
30000
Cumulative FII
10000
20000
5000
10000
0
0
Closing Sensex
Possibly a Pan-Asian Problem
The critique
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Focus of the critique of financial liberalisation
has been on exernal liberalisation.
Seen to have resulted in an increase in
external vulnerability and financial fragility in
developing countries
Corroborated by the spate of financial crises
during the 1990s, by which time adjustment
to the debt crises had substantially liberalised
financial markets
Transformation of financial structures
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A parallel fall-out is the transformation of
financial structures, defined as the markets,
institutions and instruments that define the
financial system.
Given the common framework, tendency is to
homogenise financial structures across
developing countries
Make them resemble some idealised AngloSaxon model of transparent and efficient
markets
Financial crises in EMEs
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Fragility comes not only from opening up of
capital accounts to encourage the inflow of
capital.
By institutionally transforming the financial
sector in these countries liberalization
unleashes a dynamic that endows the
financial system with a poorly regulated,
oligopolistic structure, which could increase
the fragility of the system.
The underestimated threat
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Greater freedom to invest, including in
sensitive sectors such as real estate and
stock markets, ability to increase exposure to
particular sectors and individual clients,
freedom to expand exposure to retail credit
markets for purchases of housing,
automobiles and durables, and increased
regulatory forbearance all lead to increased
instances of financial failure.
Consequence is structural contagion.
The reality of structural contagion
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Countries seeking to attract capital have to liberalize
their financial policies in two ways:
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Provide space for the carriers of capital or foreign
institutions
Relax regulations relating to the markets, institutions and
instruments that constitute the financial structure to provide
an appropriate environment to global firms
Allows for the proliferation of financial institutions
and instruments and in the practice of risk transfer
through processes such as securitization
Makes growth dependent on credit financed
consumption and investment.
Impact 1: Credit Expansion
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Consider financially stable India during the 9
per cent growth phase:
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Rapid pace of expansion of total bank credit.
The ratio of outstanding bank credit to GDP
initially declined from 30.2 per cent at end-March
1991 to 27.3 per cent at end-March 1997.
Over the next decade, and especially since 2005,
the ratio of bank credit to GDP more than doubled
to reach about 60 per cent by end-March 2008.
Impact 2: Pattern of lending
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Retail loans, which witnessed a growth of
around 41 per cent in both 2004-05 and 200506, have been one of the prime drivers of the
credit growth in recent years, despite a
moderation of the growth rate to 30 per cent in
2006-07 and 17 per cent in 2007-08.
Sharp increase in the retail exposure of the
banking system, with overall personal loans
increasing from slightly more than 8 per cent of
total non-food credit in 2004 to close to a quarter
by 2008.
Maturity profile
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Steady rise in the proportion of short-term
deposits maturing up to one year since March
2001. Deposits maturing up to one year
increased from 33.2 per cent in March 2001 to
43.6 per cent in March 2008.
At the same time, the share of term loans
maturing beyond five years increased from 9.3
per cent to 16.5 per cent. While this could imply
increased profits, the increased asset liability
mismatch has increased the liquidity risk faced
by banks.
Implications
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One important consequence of this
transformation of banking was excessive
exposure to the retail credit market with no or
poor collateral. This resulted in the accumulation
of loans of doubtful quality in the portfolio of
banks.
A significant but as yet unknown proportion of
this can be “sub-prime”. According to one
estimate, by November 2007 there was a little
more than Rs.400 billion of credit that was of
sub-prime quality.
Sensitive sectors
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Exposure of the banking system to the socalled “sensitive” sectors, like the capital, real
estate and commodity markets at the end of
financial year 2008 was 21 per cent of
aggregate bank loans and advances, with the
figure comprising an 18.4 per cent
contribution of real estate, 2.5 per cent
contribution of the capital market and a small
0.1 per cent from commodities.
Off balance sheet exposure
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Off-balance sheet (OBS) exposure has
increased significantly in recent years,
particularly in the case of foreign banks and
new private sector banks. The ratio of OBS
exposure to total assets increased from 57
per cent at end-March 2002 to 363 per cent
at end-March 2008.
The spurt in OBS exposure is mainly on
account of derivatives whose share averaged
around 80 per cent.
Increase in securitisation
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Finally, the Indian financial sector too had
begun securitizing personal loans of all kinds
so as to transfer the risk associated with
them to those who could be persuaded to buy
into them.
As the US experience had shown, this tends
to slacken diligence when offering credit,
since risk does not stay with those originating
retail loans.
Implication
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Conventional indicators notwithstanding the
banking sector is not all safe.
Credit stringency, generated by financial
fragility, the exodus of capital from the
country for example or the uncertainties
generated by the threat of default of retail
loans that now constitute a high proportion of
total advances could freeze up retail credit
and curtail demand.
Impact on real economy
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Since growth in a number of areas such as
the housing sector, automobiles and
consumer durables had been driven by
credit-financed purchases encouraged by
easy liquidity and low interest rates, the
curtailment of credit provision by a damaged
or cautious financial sector could adversely
affect growth.
What then explains the post-crisis recovery?
Note the revival in Capital Inflows
Asia: The main attractor of equity
Bank credit to private sector
Some questions
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Another liquidity-driven and credit-financed
boom?
Does strucutural weakness lie below the
ostensible financial strength of Asia and its
robust recovery?
Does developing Asia too have a stake in the
reform and restructuring of the financial
sector and the framework of financial
regulation?
The Chinese case
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In 1986, reform of the non-bank financial
sector resulted in the creation of a number of
trust and investment companies, and
financial intermediaries such as leasing
companies, pension funds and insurance
companies.
Subsequently, foreign banks were allowed to
begin business for the first time.
China: Credit-led recovery
Recent changes in finance
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The changes in the financial system accelerated after 2008,
when to provide more stimulus the government allowed or
encouraged more “informal” credit flows that went through
new shadow banking intermediaries.
In addition to trust companies and private banks, which are
not regulated but are registered businesses with
established offices, there has been a proliferation of
underground operators, providing largely unsecured loans
at high rates.
Even large local state-owned firms whose main business
was not finance are now expanding into operating
guarantee companies, pawnshops and trusts, arbitraging
their own access to cheap loans to lend out at many
multiples of the official interest rates.
The demand side
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On the face of it, China’s household sector
appears to be not excessively leveraged at all
– rather, they are substantial net financial
savers. However, China’s official financial
statistics still do not cover shadow banking
entities. But even without these, the data
indicate that the ratio of liabilities to assets
has been rising quite rapidly.
Real estate
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Much of new credit went into the overheated
housing market, associated not just with a
construction boom but with urban real estate
prices that are now the highest in the world
for cities like Shanghai and Beijing. Even
formally, direct loans from Chinese banks for
real estate and housing increased
significantly in the previous two years.
Financial inter-linkages
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The growing but opaque interlinkages between
the formal credit system and the world of
shadow banking a problem.
Formal banks are also more attracted to indirect
lending that generates at least double or triple
the official 6.5 per cent one-year lending rate,
and can even go up to 30-70 per cent in
underground banks.
In the first half of 2011, the most profitable
activity of state-owned banks was not lending to
businesses but funding trusts and underground
banks.
Implication
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Structural contagion has its consequences
Banking practices and activities of nonbanking companies begin to resemble the
“model”.
Outcome could be increased fragility unless
regulation not restored.
Further, the capacity of the financial system
to serve as an instrument for inclusive
development undermined.