Chapter 11. Operating within the New Global Regulatory Environment
- Ratna Sahay, Cheng Lim, Chikahisa Sumi, James Walsh, and Jerald Schiff
- Published Date:
- August 2015
- Rina Bhattacharya, James P. Walsh and Aditya Narain
Main Points of this Chapter
Asian banks tend to be well capitalized and liquid, with broadly strong supervision—although there are some gaps.
Crisis management frameworks are strong in most countries, but bank resolution remains an issue.
Policymakers must address the issue of institutions considered “too important to fail” in Asia, particularly because the region has relatively few globally systemically important financial institutions.
Extending the regulatory perimeter to nonbank lending, particularly in rapidly growing areas such as shadow banking, will be essential.
Spillovers from the global regulatory reform agenda are likely to be contained.
Asia is home to a wide and diverse range of financial sectors. The region encompasses several advanced economies (Japan, Australia, and New Zealand), international financial centers (Singapore and Hong Kong SAR), emerging market economies (China, India, Malaysia, and Thailand), and still-developing economies (Bangladesh, Cambodia, Lao P.D.R., Myanmar, and Nepal). Japan and China are home to global systemically important financial institutions (G-SIFIs)—three in Japan and two in China. Other countries have institutions that are domestically systemically important and must guard against the contagion effects of the distress of these institutions on other entities in the system. The degrees to which the preconditions for successful regulatory and supervisory frameworks are met vary widely, but some regional similarities exist.
Chief among these similarities has been the response to past financial crises. As discussed in Chapter 5, the Asian financial crisis had a profound effect on policymaking. The region’s willingness to overhaul financial regulation and supervision after the crisis contributed to its resilience during the global financial crisis, and continues today as new risks are identified and as the global regulatory reform agenda gets under way.
At the top of this agenda are new requirements under Basel III, which Asian countries have already begun to adopt. On the surface, the very success of Asia’s well-capitalized and highly liquid banks seems to imply a minimum of difficulty in adhering to new capital and liquidity requirements, but the need for robust risk-assessment frameworks and stepped-up demand for high-quality liquid assets do present challenges for some systems and some institutions. The implementation of these new regulatory shifts in the rest of the world will also have spillover effects in Asia.
Even at home, the very nature and success of Asia’s growth models have created new challenges. Deeper and more complex financial sectors mean more potential for systemic risks, and here, Asia’s experience with previous financial dislocations has led it to become a world leader in macroprudential frameworks. Rising integration, in Asia as elsewhere, has lowered costs and diversified risks. However, it has also heightened the need for cross-border cooperation in supervisory and, in times of crisis, resolution frameworks.
Larger financial sectors also lead to larger financial institutions. The emergence, both actual and hoped for, of regional financial champions will run up against global concerns about “too-important-to-fail” banks, an area in which Asian supervisors, along with their global colleagues, have found it challenging to mitigate risks. At the other extreme, a diverse and rapidly growing sector of nonbank financial institutions poses challenges for regulators as interconnectedness and complexity rise. These firms have helped broaden access to finance and have increased competition in some countries in which banking has not been especially competitive. At the same time, however, rapid growth and tighter regulation of banks means the perimeter of regulation needs to be rethought.
This chapter explores each of these themes. The section titled “Asia’s Banking Sectors” assesses the framework for supervising banks in Asia, and looks at what changes will be necessary to further improve stability and bring the region in line with global reforms. The section titled “Macroprudential Policy Frameworks” looks at systemic financial risks and macroprudential policy, and the section titled “Nonbank Issues” looks at the changing role and supervisory priorities for nonbanks.
Asia’s Banking Sectors
Asia’s experiences during the Asian financial crisis of the late 1990s and the global financial crisis of 2008–09 spurred an effort to strengthen the regulation and supervision of the region’s banks:
The Asian financial crisis prompted many Asian economies, both emerging market and advanced, to embark on ambitious financial sector reforms. Identified gaps in regulatory and supervisory frameworks were addressed through new laws and institutions. Policy measures were taken to strengthen risk-management policies and corporate governance, and supervisory agencies were given enhanced powers to intervene and conduct regular examinations, both on site and off site.
After the global financial crisis, many emerging market economies also took measures to upgrade their financial market infrastructures (Chapter 5). Countries in Asia that were less directly affected by the crisis (such as China and Sri Lanka) improved the quality and timeliness of supervision—often through existing prudential criteria or by restructuring supervisory processes. Several countries reformed their legal frameworks by clarifying supervisory mandates and powers. Some also sought to improve their financial infrastructures, such as by establishing deposit insurance and credit registries (Schneider and others 2015). As a consequence, banks in emerging Asian economies were in a better position to cope with the direct and indirect effects of the global financial crisis, and were, therefore, relatively unaffected by it.
The global financial crisis affected advanced Asian economies more significantly than it affected Asian emerging market economies. The advanced economies are where G-SIFIs play a major role, and where domestic regulatory changes have mirrored developments in other advanced economies. For example, Japanese and Australian banks expanded their cross-regional lending activities in Asia as European banks deleveraged from the region.
At the same time, Asia is part of the global initiative to reform regulation and supervision. Priorities include implementing Basel III capital regulations; strengthening prudential supervision by securing resources for and independence of supervisors; restoring confidence in bank balance sheets; developing and implementing effective domestic and cross-border resolution regimes, especially for systemically important financial institutions (SIFIs); facilitating implementation of over-the-counter derivatives reforms through further cross-border coordination; and enhancing the monitoring of shadow banking (IMF 2014b; and FSB 2012b).
Capital and Liquidity
Most Asian countries have taken, or are in the process of taking, measures to fully implement Basel III capital and liquidity requirements. Basel III phase-in arrangements require Tier I capital (including a capital conservation buffer of 2.5 percent) to rise steadily to a minimum of 8.5 percent of risk-weighted assets by January 2019, and Common Equity Tier 1 capital to rise steadily to 7.0 percent of risk-weighted assets. In addition, the Basel III requirements call for an additional countercyclical buffer of up to another 2.5 percent of risk-weighted assets.
The latest progress report by the Basel Committee on Banking Supervision (BCBS) shows that the final rules for the Basel III capital requirements are already in force in many Asian economies (see Tables 11.1 and 11.2; BCBS 2014). As of September 2014, all reporting Asian countries had legally adopted the final Basel III–based capital regulations. The BCBS is also currently assessing the quality of implementation of its members through Level 2 assessments of its Regulatory Consistency Assessment Program (RCAP). Regulatory authorities in Japan and Singapore have amended their domestic regulations, contributing to more consistent national implementation of the Basel III framework. The preliminary results for China have been encouraging—China has so far promptly rectified issues identified by the RCAP reports and is continuing with regulatory reforms.
|Australia||Draft rules to implement Basel III liquidity requirements issued in November 2011. Final rules to implement Basel III capital requirements issued in September 2012.|
|Hong Kong SAR||Draft rules to implement Basel III capital requirements and associated disclosure requirements issued in August and June 2012, respectively.|
|Japan||Implementation of Basel III started end-March 2013 (except for capital conservation buffer and countercyclical buffers, which are expected in 2014/15).|
|New Zealand||Implementation of Basel III to start January 1, 2015.|
|Singapore||Final rules for implementation of Basel III published on September 14, 2012.|
|Korea||Draft rules to implement Basel III published in September 2012.|
|Bangladesh||Preparing to implement Basel III from 2014.|
|China||New capital regulations that combine Basel II, 2.5, and III were released in June 2012 and became effective January 1, 2013.|
|India||Final rules for implementation of Basel III issued in May 2012 and came into force January 1, 2013.|
|Indonesia||Consultative paper on Basel III, which contains draft regulations for implementation of Basel III, was released in June 2012 for industry comments.|
|Malaysia||Intends to follow the BCBS’s timetable for implementation of Basel III, with capital and liquidity requirements to be phased in over the period 2013–19.|
|Philippines||The Philippine Central Bank approved the implementing guidelines of the revised capital standards under the Basel III Accord in January 2013. Universal and commercial banks are required to meet the standards by January 1, 2014.|
|Sri Lanka||Intends to follow the BCBS’s timetable for implementation of Basel III, with capital and liquidity requirements to be phased in over the period 2013–19.|
|Taiwan Province of China||Intends to follow the BCBS’s timetable for implementation of Basel III, with capital and liquidity requirements to be phased in over the period 2013–19.|
|Thailand||Basel III capital adequacy requirements implemented January 1, 2013.|
|Vietnam||Partial adoption of Basel I, no firm plans to implement Basel III.|
|Basel II||Basel 2.5||Basel III||Total|
(Maximum = 48)
(6) = (1)×(2) +
|Basel Capital Progress|
(Basel II and 2.5)
(7) = (6)/48
|Hong Kong SAR||4||6||4||6||2||4||48||1.00||1.00|
However, some Asian countries may need to slow the moves their industries are taking to the internal-model-based approaches to computing regulatory capital given the problems in ensuring consistent implementation revealed in recent cross-country studies. The RCAP reports found considerable variations in average risk-weighted assets for credit risk across large banks, a significant portion of which is not explained by portfolio differences and points instead to inconsistent interpretation and implementation. The higher capital requirements arising from the reform agenda may create incentives for banks to use the advanced internal-ratings-based approach, instead of the standardized approach, to achieve lower implicit risk weights with the same balance sheets. Alternatively, banks might restructure business lines toward more nontraditional banking activities that conserve risk-weighted assets, particularly those activities that require strong supervisory capacity and experience to monitor proper implementation.
Implementation of the Basel III liquidity and leverage regulations could be more challenging. This is likely to be the case for countries with shallow financial markets and a lack of high-quality liquid assets used in the calculation of the liquidity coverage ratio and the net stable funding ratio. Also, foreign currency risk may increase if banks use foreign currency assets to meet shortfalls of liquid assets in domestic currency. The Basel Committee proposed several approaches for addressing the scarcity of high-quality liquid assets, including allowing banks to access contractual committed liquidity facilities provided by the relevant central bank for a fee. Australia, for example, in November 2011 introduced such a facility. The fee-based approach would give supervisors discretion to allow banks to hold liquid assets in a currency that does not match the currency of the associated liquidity risk,1 or to allow banks to hold additional Level 2 assets (such as corporate debt). However, these strategies to address the scarcity of eligible high-quality liquid assets could expose banks to higher market and credit risk, as well as to foreign currency risk.
Overall, global regulatory reforms are likely to have only a small impact on Asian lending rates. Higher capital and liquidity safety margins required under the global regulatory reforms, outlined elsewhere in this chapter, will lead to an increase in lenders’ operating costs. There is disagreement, however, about how much the additional safety margins will cost in terms of higher lending rates.2Elliot, Salloy, and Santos (2012) find a notably smaller impact than did earlier studies, in part because of the assumption that equity investors will reduce their required rates of return on bank equity as a result of the safety improvements, and that banks will take measures to reduce costs in response to the regulatory changes (Figure 11.1). On average, the estimated impact of the regulatory reforms on bank lending rates in Asia is relatively small.
Figure 11.1Projected Impact on Lending Rate by Various Studies
Sources: IIF (Institute for International Finance); OECD (Organisation for Economic Co-operation and Development); BIS (Bank for International Settlements); and IMF (International Monetary Fund).
There is evidence that cooperative and rural banks in Asia are less financially sound and profitable than are Asian commercial banks. This lack of soundness is reflected in the stress test results reported in recent Asian Financial Sector Assessment Program (FSAP) reports, including the Financial System Stability Assessment (FSSA) for Australia.3 However, there are important exceptions. For example, several regional banks in Japan are affected by low core profitability, relatively thin capital positions, and large duration gaps, making them particularly vulnerable to slow growth and market yield shocks. Among emerging market economies, the FSSA for India notes that, although stress tests confirm that commercial banks are well positioned to withstand a range of severe shocks, this is not the case for a significant majority of noncommercial banks (notably, regional rural banks and cooperative credit institutions that target underserviced rural and urban populations). The banking sector in the Philippines appears to be generally resilient to a broad range of macroeconomic risks, but the asset quality of thrifts, cooperatives, and rural banks is relatively weak, and provisions are low. Basic stress tests of Bangladesh’s commercial banks suggest that credit risk continues to be a particular concern.
Crisis Management and Resolution
Another strength identified by some recent Asian FSAP reports is generally robust crisis management frameworks. Japan, for example, has developed a robust and time-tested crisis management framework. Malaysia, India, and Thailand have in place sound crisis management frameworks to facilitate prompt and coordinated action in the face of a crisis, and the Bank of Thailand’s contingency planning and business continuity framework is also advanced. In contrast, the FSSA for Indonesia (published in September 2010) concludes that important gaps remain in crisis management and in dealing with problem banks, and that supervisory powers to intervene and resolve insolvent insurance companies are incomplete. Since then the Indonesian authorities have taken steps to improve their Prompt Corrective Action framework. In China, a more robust framework is needed to resolve weak financial institutions in a timely manner. In Thailand, too, the pace of disposal of stressed assets is slow, and there is a need to move to a more transparent and well-defined process for addressing troubled financial institutions.
Bank resolution frameworks present a more mixed picture. Singapore’s solid legal framework for crisis management includes an excellent resolution regime, with tools and responsibilities clearly allocated among several public bodies, and robust arrangements for information sharing and coordination. In Thailand, however, the FSSA comments on the slow pace of disposal of distressed assets acquired by asset management companies and the need to move to a more transparent and well-defined process for addressing troubled financial institutions. China and India also need more robust frameworks to resolve weak financial institutions in a timely manner.
Too Important to Fail
Addressing the too-important-to-fail problem in Asia is urgent but efforts to do so could face legal and regulatory challenges. The Key Attributes of Effective Resolution Regimes for Financial Institutions (Financial Stability Board 2011) seeks to ensure that national frameworks are designed in a manner that enables and encourages authorities to cooperate with their counterparts in other jurisdictions in the resolution of a cross-border financial institution or group. Clifford Chance and ASIFMA (2013) find that most advanced Asian economies (Australia, Japan, Korea, and Singapore) as well as Indonesia, have in place “special resolution regimes” aimed at meeting these attributes, but this is not so in China, India, and Hong Kong SAR.
Several powerful forces could push already-large financial institutions in Asia to become even larger. These forces include a funding advantage for financial institutions believed to be “systemic” or too important to fail and, thus, implicitly backed by the government;4 remuneration schemes linked to size or number of deals rather than risk-based profitability; and a belief that a “full-service” global bank is necessary to service clients requiring global reach and broad product capabilities (Kodres and Narain 2010). For example, large Korean firms are reported to prefer global banks, such as Citibank, as their financial partners for global projects because Korean banks cannot provide, on competitive terms, the comprehensive financial services they need. This situation may spur domestic institutions to become both larger and more complex, as discussed in Chapter 6. In addition, the depression of return on equity observed during the global financial crisis may influence behavior. If investors in financial institutions continue to demand precrisis rates of return on equity, there is a clear risk of further concentration of trading activities in even fewer global institutions as these investors attempt to combine their funding advantages with economies of scale.
At the same time there are forces pushing in the opposite direction. Many features of the global regulatory reform agenda are explicitly aimed at changing the existing financial landscape and making it more expensive to become systemically important. Moreover, as the Global Financial Stability Report October 2012 (IMF 2012) points out, banks that focus on commercial banking with a stable retail deposit base, particularly smaller banks, would be considerably less affected by the Basel III liquidity requirements than would those that focus on investment banking—with universal banks falling in between. In this context, regulatory reforms, when combined with measures taken by many emerging market Asian economies to promote financial inclusion and extend banking services to underserved regions and segments of the population, may actually promote the development of smaller, cooperative banks that can meet the credit needs of small and medium-sized enterprises and many households, while also providing profitable outlets for investing their savings.
The most likely outcome will be a more bifurcated financial system, with some financial institutions becoming larger and others opting for a more focused business model. Some banks may be willing to pay the de facto “systemic risk tax” and remain large or even grow larger, taking advantage of their too-important-to-fail status and their belief that governments will come to their rescue if they run into serious financial difficulties (Kodres and Narain 2010). Other financial institutions may prefer to avoid the additional costs associated with systemic importance by retreating from some business lines, and by effectively shrinking in size to avoid paying the systemic risk tax. Regulatory efforts, such as capital charges, can help lean against the drivers behind too important to fail.
A regional comparison of compliance with international regulatory and supervisory standards shows Asia performing as well as, or even better than, other regions. This is shown in Figure 11.2. On Basel Core Principles (BCP) standards, Asia appears to perform particularly well in corrective and remedial powers of supervisors.5 For example, the Singapore FSSA states that the country’s current regulation and supervision of its financial institutions are among the best globally. However, a more detailed regional comparison of BCP (2006) Core Principle 1 shows that Asia’s compliance with standards relating to independence, accountability, and transparency of supervisory agencies is relatively low, even though supervisors do enjoy high levels of legal protection. With regard to insurance, Asia has shown strong compliance with International Association of Insurance Supervisors standards on supervision and disclosure. However, as with the BCP standards, Asia shows relatively low compliance with standards on independence (autonomy) and powers of supervisory agencies. With regard to compliance with the International Organization of Securities Commissions standards for regulation of securities markets, Asia performs particularly well on interagency cooperation and accounting and disclosure standards.
Figure 11.2Regional Comparison of Compliance with International Standards on Regulation and Supervision
Source: Standards and Codes Database.
Note: BCP = Basel Core Principles; IAIS = International Association of Insurance Supervisors; IOSCO = International Organization of Securities Commissions.
Recent FSAP reports on Asian countries have highlighted a number of pressing areas for strengthening regulation and supervision of these countries’ financial sectors (Table 11.3). These reports suggest that reform priorities vary somewhat from emerging market to advanced Asian economies. At the same time, several common challenges must be addressed by almost all countries in Asia. Key reform measures proposed by the IMF include (1) reinforcing staff and technical capacity at supervisory agencies, particularly in the form of risk-based supervision and surveillance of nonbank financial institutions; (2) reducing concentration risk by tightening the definition and monitoring of “connected lending” (that is, large exposures to single borrowers, related parties, or both)—a key recommendation in almost all Asian FSAPs; and (3) promoting better risk-management practices in financial institutions through stronger regulation and enhanced disclosure requirements. India, for example, has a large exposure limit of 55 percent of a banking group’s capital, which is much higher than the international practice of 10–25 percent, depending on the borrower and collateral.
|Framework for Prudential Regulation and Supervision|
|Crisis Management and Bank Resolution|
|Role of Government|
The Thailand FSSA notes that, in the period between the Financial Sector Assessment Program discussions and the finalization of the report, Thailand had passed a number of critical legal financial sector reforms that addressed most of the legal and regulatory shortcomings identified in the assessments of the regulatory and supervisory standards. Nevertheless, there was too little time to assess implementation of the legal reforms.
Several Asian FSAP reports highlight the need for national supervisory agencies to develop and strengthen their frameworks for consolidated supervision. Conglomerates are an important feature of many Asian economies and, as mentioned earlier, their links to the state further challenge effective consolidated supervision. In the Philippines, for example, about 60 percent of bank assets are controlled by banks that belong to conglomerates. Furthermore, a large proportion of listed companies (estimated to be 75 percent of effective market capitalization) also belong to conglomerates. For the moment, most Asian banks are focused on relatively straightforward traditional deposit-taking and lending activities. However, as these institutions become more complex, and move into new areas of business, the need for consolidated supervision will further increase.
Strengthening cross-border cooperation and information exchange on regulation, supervision, and resolution of financial institutions should be a high priority for many Asian countries. As Asian banks and financial institutions expand their cross-border operations, it is important that both home and host countries have (1) sufficient data and information to regulate and supervise these banks and institutions effectively, and (2) the necessary resolution tools and capacity to cooperate across borders to resolve these institutions without systemic disruption and without exposing taxpayers to losses. Although Singapore is an important international financial center, the 2013 FSAP identified the further facilitation of cross-border cooperation in bank resolution as a reform priority. Moreover, in India, domestic banks have established overseas operations in more than 45 jurisdictions, but there are material gaps in information flows with overseas supervisors. However, the Reserve Bank of India has memoranda of understanding with only two overseas counterparts, and limited informal arrangements with others, and overseas inspections are also not conducted regularly. In other countries with less integrated financial sectors, progress lags even further.
Data gaps and weak legal frameworks hamper supervision across the financial sector. Some needed reforms include the following:
Improving the availability, timeliness, and quality of financial sector data, as well as the technical capacity to analyze them and take appropriate actions if needed. For example, the FSSA for China notes the difficulty of assessing the magnitude of potential risks to the Chinese financial system, and how these risks could permeate through the economic and financial system, given the data gaps, the lack of sufficiently long and consistent time series of key financial data, and the weaknesses in the information infrastructure.
Strengthening loan classification and provisioning practices and enforcement of prudential standards.
Improving accounting and auditing rules and practices and bringing them up to international standards. This has been identified as an important priority for Bangladesh, China, Indonesia, and Thailand.
Providing greater autonomy and independence to central bank and supervisory agencies, and ensuring legal protection for all supervisory staff.
The Role of the State in Asia’s Financial Systems
A defining feature of the Asian financial systems continues to be the high degree of government involvement in financial intermediation. These close interactions have led to some specific outcomes across the region which, collectively, may restrain market development. Examples include the following:
Reliance on rules-based approaches—Asian regulatory frameworks tend to be rules-based, with a focus on achieving compliance with these rules. Excessive reliance on rules-based supervision often detracts from supervisors’ using their own judgment and employing forward-looking, risk-based supervisory techniques.
Limited supervisory independence—This is reflected in insufficient or ineffective corrective action frameworks because supervisors are challenged in disciplining the state and its agents. The China FSAP shows how the operational autonomy of supervisors is often undermined by the use of the commercial banking system for development purposes. The Malaysia FSAP points to the need to address existing legal provisions that can undermine the operational independence of supervisors. The India FSAP calls for greater de jure independence of all regulatory agencies.
Weak implementation of rules on large exposures and related-party lending—These rules are often not observed because the state seeks to direct bank credit to fund activities and institutions considered important in national contexts. In India, for example, state-owned banks have been major conduits for funding large public sector projects deemed to be of national importance. The FSAP points out that these large exposure limits are almost double those considered good practice internationally. The Malaysia FSAP points to the need to strengthen the definition of both connected lending and related lending.
Inadequate institutional frameworks for consolidated supervision—State ownership of major players in the financial system complicates consolidated supervision of conglomerate structures spanning state-owned players in the banking and nonbank sectors.
Weaknesses in bank recovery and resolution frameworks—State ownership can hamper recovery and resolution efforts by supervisors. For example, in Thailand, the FSAP finds that continuing state involvement in asset management companies has led to reduced recovery rates of nonperforming loans and recommends that the state take more effective measures to reduce its stake in intervened commercial banks and that the central bank refrain from managing and owning such stakes.
Reducing state involvement can pay significant dividends. China, India, and Vietnam should consider gradually phasing out administrative controls and promoting market-based measures for regulating the financial system, as well as divesting government ownership of banks and strengthening governance in state-controlled banks and other financial institutions. Such measures would help improve the profitability and strengthen the balance sheets of their financial sectors by increasing the commercial orientation of their financial institutions. These measures would also place the state-owned banks in a stronger position to cope with the challenges posed by the growing size, complexity, and interconnectedness of the financial sectors.
Spillovers from Global Regulatory Efforts
The emphasis in the reform agenda on raising the cost of riskier activities could affect Asia both directly and indirectly. Basel III and globally systemically important bank surcharges, aimed at addressing too-important-to-fail problems (discussed elsewhere in this chapter), will raise the cost of borrowing from such institutions. Structural measures that restrict certain risky business activities or ringfence retail from wholesale banking will add to these effects. These regulatory initiatives could have a direct impact on Asian financial institutions, or they could indirectly affect Asian financial markets, if globally active foreign banks alter their exposures to Asia.
Global regulatory reforms may encourage internationally active banks to lower their exposure to Asia by deleveraging or shifting their activities. Higher liquidity requirements under Basel III, as well as G-SIFI surcharges, may increase the cost of operating in some jurisdictions and negatively affect cross-border lending and investment activities—or prompt changes to banking group structures. The impact is likely to be mitigated to the extent that highly liquid banks in mature Asian markets such as Japan, Hong Kong SAR, and Taiwan Province of China decide to expand their lending activities in fast-growing emerging Asian economies that offer profitable investment opportunities such as India, Indonesia, Thailand, and Vietnam (Wyman 2012).
National regulatory reforms in advanced economies designed to restrict and ringfence the activities of domestic financial institutions could prompt international banks to retrench from their operations across Asia. Although the effects are difficult to quantify, these reforms could induce parent banks in advanced Western countries to alter their global business models and lower their exposures to Asia, either by reducing direct lending or by cutting back on their activities in derivatives and securitization markets in Asia. Foreign parent banks may reduce funding to their local branches and subsidiaries in Asia, forcing them to raise funding locally or to reduce their local lending activities. Cross-border lending may be further adversely affected if Asian economies start ring-fencing their domestic financial institutions by placing limits on the size and scope of their activities (Viñals and others 2013).
However, pressures for deleveraging are likely to be mitigated by two factors:
First, the global financial crisis suggests that retrenchment by Western banks had not posed a significant problem, at least for those countries with sound macroeconomic policies and strong growth potential. In many cases, deleveraging by Western (mainly European) banks in Asia was offset by increased lending by regional Asian banks, notably Australian and Japanese banks (Figure 11.3).
Foreign banks, on average, have a relatively low presence in Asia, compared with their presence in other regions. This is true whether their presence is measured by their share of the total number of banks operating in the country, or by the share of total bank assets in the region. Nonetheless, there is considerable cross-country variation, with a high foreign bank presence in Australia, Hong Kong SAR, and Singapore, and a low foreign bank presence in China, Japan, and India.
Figure 11.3Australia, Europe, and Japan: Cross-Border Bank Exposures to Asia
Source: Bank for International Settlements - Table 9D (data extracted February 4, 2014).
Note: Asia excludes Australia and Japan; Europe excludes the United Kingdom.
Macroprudential Policy Frameworks
FSAP reports recommend that many Asian countries strengthen their monitoring of systemic risks and enhance their frameworks for macroprudential supervision. The FSSA for Australia, for example, recommends that the country devote more resources to stress testing to enhance the ability of the Reserve Bank of Australia to identify and monitor emerging systemic risks. The FSSAs for China, Indonesia, and Japan make similar recommendations. Also important in this context is the need to enhance cooperation and the exchange of information among domestic supervisory agencies. The FSSA for Japan, for example, recommends bolstering oversight of systemic risk through more regular interagency information sharing and enhanced cooperation on macroprudential policy and contingency planning. Similar recommendations were made for China, India, Indonesia, the Philippines, and Thailand.
Nevertheless, some countries have put in place innovative elements in their macroprudential policy frameworks. Indeed, Asia as a region has been ahead of advanced economies in implementing macroprudential policies. India, for example, has been a pioneer in the use of macroprudential policy and has made continued efforts to strengthen systemic oversight, facilitated by a policy coordination structure that brings together major stakeholders under the leadership of the finance ministry and the central bank. Malaysia has made effective use of sectoral macroprudential instruments to limit the risks posed by strong growth in unsecured personal loans and residential mortgage loans. Several Asian countries have also been innovative with liquidity tools designed to reduce vulnerabilities from a system-wide increase in wholesale, short-term, and foreign exchange funding. These tools include the introduction of a Macroprudential Stability Levy by Korea in August 2011, and a Core Funding Ratio by New Zealand in October 2009 (IMF 2013).
Asian securities regulation is broadly in line with global International Organization of Securities Commissions standards. The region performs particularly well in interagency cooperation and accounting and disclosure standards, but areas for improvement remain. For example, a reform priority identified by the FSSA for Australia is to ensure adequacy and stability of core funding for the Australian Securities and Investments Commission so that it can carry out proactive supervision. The FSSA for Japan calls for strengthening oversight of securities firms through expanded and more risk-based inspection programs, extending auditing requirements, and improving the registration process. Among emerging market economies, for Bangladesh a key FSSA recommendation is to address urgently the shortage of resources of the securities regulator, and to provide the Securities and Exchange Commission with greater autonomy in budget and personnel decisions and rules enforcement.
Nonbank Finance and Shadow Banking
Nonbank financial intermediation remains relatively small in most countries. As discussed in Chapter 2, among the Asian countries for which data are available, only in Korea do the assets of nonbank financial intermediaries constitute more than 50 percent of total bank assets (FSB 2013a).6 The recorded assets of Asian nonbank financial intermediaries constitute a small share, less than 15 percent, of the global total; only two Asian countries—China and Japan—have a share of 3 percent or more of the global total (Figure 11.4). However, as it has expanded, the nonbank sector has become increasingly complex and interconnected with the rest of the financial system.
Figure 11.4Share of Assets of Nonbank Financial Intermediaries at End-2012
Source: Financial Stability Board (2013a).
Nonetheless, the nonbank financial sector has been growing fairly rapidly in Asia and posing additional challenges for regulators and supervisors. In 2012, nonbank financial intermediation grew by more than 20 percent in China and India, and by more than 10 percent in Indonesia and Korea. Against this background, the FSSA for Japan recommends that the Bank of Japan extend its stress-testing analysis to a wider range of financial institutions, including systemically important nonbank financial institutions. In a similar vein, the FSSA for China notes that, as the range of financial services on offer widens, so should the regulatory and supervisory perimeter. The FSSA also calls for stronger supervision of financial groups and robust systemic oversight.
Tightening bank regulation may push financial intermediation outside the banking sector and toward capital markets or shadow banking. Higher capital requirements and other regulatory constraints on banks will raise the cost of bank credit and likely prompt companies to access credit through capital markets (for example, equity and corporate bond markets) or through the shadow banking system. The 2010 China FSAP lists shadow banking (“the rise of off–balance sheet exposures and of lending outside of the formal banking sector”) as one of the key risks to near-term domestic financial stability.
Still, nonbank finance is not expected to challenge the primacy of bank finance in the foreseeable future. Several factors are working against a declining trend in the size of the banking sector (relative to GDP or to total financial sector assets). These factors include the funding advantage that banks have compared with nonbanks, particularly banks that are seen by investors as too important to fail, as well as their access to central bank liquidity support. And several Asian countries, including India, Indonesia, the Philippines, and Vietnam, have strong medium-term economic growth potential and rapidly growing working-age populations—some 40 percent of which have an account at a formal financial institution. The demand for banking services in these economies is likely to grow rapidly. It is also important to note that several emerging market Asian economies, such as India, are taking active measures to promote financial inclusion and extend banking services to underserved areas.7 Moreover, quite a few countries in Asia have large state-owned banks that are unlikely to be privatized soon. These factors may well serve to offset any impact on the cost of capital resulting from regulatory changes.
The rising importance of nonbank financial institutions points to the need to extend crisis frameworks to cover them. The Financial Stability Board argues that a priority focus of policymakers should be not just reform of crisis management and resolution regimes for banking institutions, but also the strengthening of crisis management and resolution regimes for nonbank financial institutions (FSB 2013b). The FSSA for Japan, for example, states that an effective resolution regime needs to extend to systemically important nonbank financial institutions as well as banks.
Progress in this area has been slow. Several countries, including Australia, have made substantial headway in these areas and are taking steps to introduce resolution powers and tools consistent with the Key Attributes of Effective Resolution Regimes for Financial Institutions (FSB 2011) endorsed by the Group of 20 at Cannes in 2011. Even in advanced Asian economies, with fairly well-developed resolution regimes for banks, considerable progress is still needed on resolution regimes for insurers, and securities and investment firms. In countries lacking such frameworks for banks, progress is correspondingly slower. Moreover, many jurisdictions in Asia have not yet given their national resolution authorities the framework and powers needed to resolve financial groups and conglomerates.
Corporate Bond Markets
Global regulatory reforms are likely to promote the development of domestic capital markets, particularly if accompanied by supportive national policies. As discussed in Chapter 4, Asian banks currently hold significant amounts of government bonds but very limited amounts of corporate bonds. However, with the recent rapid growth in corporate bond issuance (and a corresponding decline in syndicated lending), this situation is beginning to change. As global and domestic regulatory reforms raise the cost of bank intermediation, and as oversight of nonbank financial institutions improves, corporate bond markets can be expected to continue to grow.
Developing country institutional investors can catalyze this process. The regulatory reforms currently on the global agenda may keep banks from playing a leading role in Asian domestic corporate bond markets to the extent that they require banks to hold more high-quality liquid assets to meet Basel III liquidity requirements and as collateral for derivatives trading. Conversely, aging populations in several countries, and demand by growing middle classes for insurance products and other savings vehicles, should spur the development of insurance and pension funds that can actively purchase corporate bonds.
It is also possible that national regulatory measures, such as the Volcker Rule, may reduce liquidity and depth in corporate bond markets, and raise the costs of debt issuance. The Volcker Rule largely prohibits proprietary trading activities by U.S. banks in the United States and abroad. It also prevents non-U.S. banks from executing or clearing their proprietary trading on U.S. financial infrastructures. Market making, underwriting, and risk-mitigating hedging are exempt, as are transactions in obligations of the U.S. government and agencies. However, in practice it may be difficult, costly, and onerous to prove that certain trading activities are market making and not proprietary trading.
However, the effects of these new rules are likely to be small. Affected economies and entities include the regional hubs of Hong Kong SAR and Singapore, the Chinese and Japanese G-SIFIs, as well as countries (such as Japan, Korea, and Malaysia) that are dependent on portfolio inflows from the United States. Nonetheless, any adverse impact will be mitigated by the increasingly important role of hedge funds in trading activities, and by the exemptions granted under the Volcker Rule for trading in foreign sovereign instruments. Moreover, as discussed elsewhere in this chapter, recent developments have provided no indication that global regulatory reforms will adversely affect the market for domestic corporate bonds in Asia.
Progress in reforming over-the-counter derivatives markets has been slow. Derivatives markets in emerging Asia are relatively underdeveloped and mostly based on over-the-counter transactions (Goswami and Sharma 2011). As members of the Group of 20, six Asian countries (Australia, China, India, Indonesia, Japan, and Korea) agreed in 2009 to implement three major reforms by the end of 2012: (1) trading all standardized over-the-counter derivatives electronically or through exchanges, and clearing them through central clearing parties; (2) reporting all over-the-counter derivatives trades to trade repositories to improve transparency and price formation; and (3) subjecting non-centrally cleared over-the-counter derivatives to higher capital requirements. However, only Japan, together with the United States and the European Union, had fully implemented these reforms by the end-of-2012 deadline. Other countries appear to be waiting for the United States, the European Union, and Japan to finalize their frameworks so that they can maximize consistency and safeguard financial market infrastructure when they reform their own frameworks.
Over-the-counter derivatives reforms are expected to bring many benefits, but regulatory authorities will need to ensure that these reforms do not unduly impede the development of derivatives trading in Asia. Global regulatory reforms relating to over-the-counter derivatives trading are designed to promote better monitoring of systemic risks and to minimize the risk of disorderly liquidation of financial contracts. However, there is considerable concern that a lack of eligible instruments for collateral could make it very difficult and costly to post collateral at central clearing parties in many emerging Asian economies, thereby impeding the development of the domestic derivatives market. Moreover, changes in the market landscape resulting from the reforms in advanced economies may not only raise hedging costs for end users in Asia, it may also place smaller domestic central counterparties at a competitive disadvantage in relation to global ones, and lead to the underdevelopment of the domestic derivatives markets (FSB 2012a).
Global regulatory reforms could further slow the development of domestic derivatives markets in Asia. In many Asian countries G-SIFIs play a critical role in securities markets and derivatives, and also in trade finance. The provision of services in these areas could therefore be negatively affected by the higher capital charges and other regulatory reforms currently being contemplated for G-SIFIs. Supply of such services could also be affected by the extraterritorial aspects of regulatory reform measures adopted, or under consideration, by advanced Western countries (Viñals and others 2013). However, it is too early to have an idea of the likely magnitude of the impact of global regulatory reforms on the composition of finance in Asia.
Some of the regulatory gaps observed in the rest of the world are absent in Asia. The region is well on its way to full implementation of Basel III capital requirements, and capital positions across the region’s main financial systems are strong. However, implementation of liquidity and leverage requirements could present challenges for countries in which financial markets are shallow or poorly developed. Crisis management is broadly satisfactory in many regions, although quite a few countries lack important tools for resolution of distressed financial institutions. In general, the impact of the global regulatory reform agenda on Asia—through national implementation and spillovers from elsewhere—is expected to be relatively limited.
Institutions considered “too important to fail” are a problem in Asia. Although the region has relatively few G-SIFIs, most countries have large and domestically systemic financial institutions. The funding advantage for such institutions, as well as a preference in the region for doing business with large diversified conglomerates, could lead domestic champions to become even larger. However, financial inclusion and regulatory measures aimed at containing “too-important-to-fail” institutions will lean against these trends. The growth of many of these institutions into more diversified and globalized financial conglomerates underscores the need for enhancing consolidated and cross-border supervision across the region.
The close relationship between the banking system and the state in many countries can negatively affect both financial sector supervision and development. In many countries, the state plays both a direct and an indirect role in the allocation of credit. This complicates independent supervision and often results in concentration of exposures and an excessive reliance on rules-based approaches. Reducing the role of the state, particularly in countries in which public banks dominate the financial system, would pay dividends by strengthening bank balance sheets and facilitating the growth of more responsive and competitive financial systems.
Regulatory reform may affect the availability of some products. Liquidity restrictions could reduce the availability of long-term capital, while a tighter focus on capital and new approaches toward risk could reduce the availability of financing for small and medium-sized enterprises. At the same time, moving derivatives trading onto exchanges and the broader effort to standardize and tighten regulation of derivatives and proprietary trading could add to hedging costs. To sustain growth, Asia’s economies will need to make regulatory changes that strike a balance between two objectives: (1) ensuring that the underlying risks are adequately reflected in the cost of capital and (2) ensuring that financing options are not unduly curtailed.
Nonbank finance remains small, but presents risks in many countries. Already, shadow banking is growing rapidly in some countries in the region, raising the possibility that innovation is moving ahead of supervisors’ ability to identify and contain risks. Regulatory reform could push more lending activity off the balance sheets of the region’s banks, adding to these problems. This calls for strengthening the framework for crisis management to cover such institutions. It also calls for supervision that is sufficiently nimble to ensure that growing interconnections in the financial system, especially between regulated and unregulated firms, do not pose significant risks.
Policymakers must distinguish between the intended and potential unintended consequences of global regulatory reforms. Many of the anticipated consequences discussed in this chapter, such as the higher cost of credit intermediation through banks and of trading in opaque derivatives instruments, are precisely what the reforms were designed to achieve. However, the reforms may also have unintended consequences. A case in point is the shift in financial intermediation toward less regulated shadow banking and a reduction in turnover and liquidity in domestic corporate and government bond markets. These trends are driven by regulatory pressures on banks to lengthen debt maturities and to hold more high-quality collateral for derivatives trading.
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Provided that the resulting currency mismatch positions are justifiable and controlled within limits agreed to by the supervisor.
For example, the Institute of International Finance (2011) projects that the proposed Basel III reforms will increase lending rates by 243 basis points in the United States, 328 basis points in Europe, and 181 basis points in Japan during the period 2012–19. By contrast, Slovik and Cournède (2011) at the Organisation for Economic Co-operation and Development project that, during a five-year transition period, lending rates will rise by only 64 basis points in the United States, 54 basis points in Europe, and 35 basis points in Japan. These projections are very much in line with a quantitative study by the Bank for International Settlements on the impact of the Basel III capital and liquidity changes on lending rates (Basel Committee on Banking Supervision 2010). A study by the IMF finds an even smaller impact, with lending rates rising by 28 basis points in the United States, 18 basis points in Europe, and only 8 basis points in Japan in the long term (Elliot, Salloy, and Santos 2012).
The FSSA is a published report written by IMF staff that details the findings of the FSAP on issues relating to financial stability (as opposed to financial development) for the particular country concerned.
Chapter 3 of the April 2014 Global Financial Stability Report (IMF 2014a) notes that systemically important banks tend to receive implicit funding subsidies that come from the expectation that the government will support large banks if they become distressed. Although financial reforms since the global financial crisis have helped reduce the size of these subsidies, estimates presented in the chapter show that they remain sizable, particularly in the euro area and, to a smaller extent, in Japan and the United Kingdom.
The BCP standards assessment is a standard component of an FSSA that assesses the country’s compliance with international standards on banking supervision and regulation.
The ratios are Korea: 55.4 percent: Australia; 26.4 percent; Hong Kong SAR: 23.5 percent; India: 19.0 percent; Japan: 18.7 percent; Indonesia: 14.3 percent; China: 10.0 percent; and Singapore: 7.0 percent.
For example, a Reserve Bank of India committee has suggested setting up specialized banks to cater to low-income households to ensure that all citizens have bank accounts by 2016. These banks would be designed to provide payment services and deposit products to small businesses and low-income households with a maximum balance of 50,000 rupees per customer, and could be set up with a minimum capital requirement that is one-tenth of what is required to set up a full-service bank. Moreover, a key eligibility criterion to obtain one of the new banking licenses issued in 2014 was the applicant’s strategy and vision for financial inclusion. The Reserve Bank of India’s recent award of a banking license to only two specialized banks, one of which is a microfinance institution, from a wide field of applicants, is in line with this vision.