Financial Risks, Stability, and Globalization
Chapter

14 International Capital Mobility and Domestic Financial System Stability: Survey of Issues

Author(s):
Omotunde Johnson
Published Date:
April 2002
Share
  • ShareShare
Show Summary Details
Author(s)
V. SUNDARARAJAN, AKIRA ARIYOSHI and İNCI ÖTKER-ROBE 

A number of developments in recent years have put the concept of financial system stability at the top of the agenda of economic policymakers. There is no clear-cut definition of what constitutes financial instability. However, a “stable financial system” has been generally defined as one in which there is a high degree of confidence that the institutions can continue to perform their contractual obligations, intermediation, and wealth management services without interruptions and outside assistance, and participants can confidently transact in the key markets at prices that reflect fundamental forces and that do not vary substantially over short periods when there have been no changes in fundamentals (see Crockett, 1997b and 1997c).1

One focus of the policy debate surrounding financial system stability is the role that capital mobility and international financial integration may play in the stability of financial systems. Capital account liberalization and international capital mobility can be seen as an extension of financial liberalization and financial system development in an international context. Experience with financial liberalization across the globe over the past couple of decades has brought to the fore some important relationships between financial liberalization and financial sector performance and stability. Mainly focusing on domestic liberalization, it has been generally agreed that if carried out effectively, through appropriate sequencing of reforms and supported by a sound and sustainable macroeconomic environment, financial liberalization would improve economic growth and efficient allocation of resources, and help develop deeper, more competitive, diversified, and efficient financial markets. At the same time, it is recognized that liberalization of financial transactions can introduce new risks and result in severe financial crises if inappropriately sequenced and insufficiently supported by necessary policies and reforms. In particular, by intensifying competition in the financial sector, liberalization removes the cushion protecting intermediaries from the consequences of bad loan decisions and management practices (Eichengreen and Mussa, 1998). Liberalization would also allow banks to expand risky activities at rates that far exceed their capacity to manage them prudently, as well as induce them to pursue risky investment projects and use expensive and potentially volatile market funding. By allowing banks to engage in complex financial transactions, including those involving derivatives instruments, liberalization could make it more difficult to evaluate bank balance sheets and strain the regulators’ capacity to monitor, evaluate, and limit risks. Country experiences have provided insight into the appropriate sequencing of domestic reforms and liberalization, including the pursuit of sound economic policies; development of monetary instruments, markets, and institutions; and building up an effective system of prudential supervision to discourage individual institutions from taking on excessive risks.

The increasingly global nature of financial markets—in part reflecting financial innovations and advances in information technology and the liberalization of international capital transactions by many countries in the past two decades—has increased the volume and mobility of capital flows across borders, made financial institutions increasingly more interdependent, and brought an additional perspective into the relationship between financial liberalization and systemic stability. The severe financial crises of the last decade—particularly those in East Asia and Russia in 1997-99, as well as in Latin America in 1994-95 and Europe in 1993—have increased the emphasis placed on the international aspects of financial instability, that is, the potential contribution to financial instability of external financial liberalization and the associated increase in capital mobility.

The impact on financial stability from external financial liberalization operates through similar channels as in the case of domestic financial liberalization—i.e., increased competition, complexity, and opportunities for excesses—but it also involves additional risk factors and unique elements inherent in capital flows and their liberalization. Certain elements of domestic financial liberalization—adopting market-based monetary policy instruments, developing liquid money and foreign exchange markets, strengthening bank balance sheets, etc.—also assume higher priority to ensure stability in the presence of capital account opening.

In addition to foreign exchange, transfer, and operational risks involved in cross-border transactions, another important element of risk is the potentially higher levels of asset price volatility and the possibility of asset price misalignments following capital account liberalization. Capital flows and asset price volatility undermine solvency of banks and their customers—for example, through the impact of unexpected exchange rate depreciation on the balance sheets of banks and nonbanks. This in turn could raise uncertainty and induce capital flow reversals. In such circumstances, weaknesses in banking systems and nonbank borrowers can limit the authorities’ willingness to use interest rates to defend the exchange rate, or more generally constrain the policy mix that would be feasible, and this could exacerbate asset price misalignments, increase the probability of speculative attacks, and provoke a currency and financial crisis. There is evidence of greater asset price volatility and misalignments in both emerging markets and industrial countries in recent years (White, 2000), while the close linkages between banking sector weaknesses and balance of payment problems have become evident since the Asian crisis (Lindgren and others, 1999; Lane and others, 1999). The increasing frequency and severity of the financial crises in recent years—reflecting, in part, the growing integration of financial markets—also raise concerns about contagion among countries and markets, and the possibility of extreme market dynamics in emerging markets due to asymmetries in size between large financial firms and small and medium-sized markets. Also, global financial integration has highlighted the need to harmonize financial system standards across countries to ensure both a level playing field and sound financial systems. These considerations have led to concerted response at both national and international levels in order to strengthen national financial systems as well as “international financial architecture.”.

This paper focuses on the international aspect of financial system stability, i.e., the additional dimensions through which capital account mobility impacts on financial system stability. Accordingly, it reviews the basic characteristics of cross-border capital flows that distinguish them from domestic transactions, analyzes the main linkages between capital mobility and financial system stability, and illustrates the positive contributions that capital mobility can have on financial sector stability, as well as the circumstances under which capital mobility may result in financial system instability. The paper also discusses alternative approaches to safeguard financial system stability with a view to maximizing the benefits of international capital mobility while minimizing its risks. In particular, it focuses on the role of consistent macroeconomic policies, prudential and supervisory framework, and other supporting financial sector reforms, as well as on the merits of resorting to capital controls in managing capital flows that may threaten financial system stability. Finally, it discusses the implications of these systemic responses for the sequencing of capital account liberalization with financial sector reforms. The last section provides some concluding remarks.2

Linkages Between Capital Mobility and Financial Stability

The 1990s witnessed a substantial increase in capital mobility and an associated growth in cross-border capital flows. Global financial markets grew significantly in size, complexity, and in the range of services and products they offered. Private capital emerged as the dominant source of development finance (see Dailami, 1999), and international financial transactions exceeded more than five times the value of the world trade.3 Parallel to this increase in financial integration, there was an explosive growth in net private capital flows to developing countries (a sevenfold increase in 1990-96 compared with the 1984-89 period). A major part of the increase reflected foreign direct investment, portfolio investments in domestic stocks and bonds, commercial bank loans, and the issue of bonds and equities in offshore markets, compared with investments in government and large corporate bonds in the earlier period. These trends were supported in general by the full liberalization of capital flows in most developed countries and further moves in that direction in many developing countries; advances in communication and information technologies that reduced cross-border transaction costs and information asymmetries; the development of new financial instruments; improved legal, accounting, and regulatory systems; and macroeconomic and structural developments in the capital importing countries that improved their creditworthiness and expanded investment opportunities.

Characteristics of Cross-Border Capital Flows That Impinge on Financial Stability

Increased mobility of capital across borders could have important implications for financial system stability over and above those associated with domestic financial flows and their liberalization. While in some aspects the differences between domestic and external liberalization are a matter of magnitude, the effect can be dramatically larger so as to be qualitatively different, particularly with respect to small economies when they are opened to external flows. Other aspects are more unique to external liberalization and flows.

In broad terms, as with domestic financial liberalization and development, growth in cross-border capital flows and the growing sophistication of financial instruments allow more efficient risk allocation and arbitrage, and thus increase the potential investment opportunities for an investor, while offering the recipients of funds additional and cheaper access to finance. To summarize:

  • the additional investment opportunities open access to potentially higher returns for investors and lower funding costs for borrowers, as well as allowing greater risk diversification, but they also create an opportunity to take on excessive risk;

  • cross-border capital flows can widen the range and increase the number of participants in a market and hence could enhance efficiency and liquidity, but the market could become more volatile if those new entrants cause swings in flows that are large relative to the stock of assets in the market; and

  • cross-border flows strengthen the linkages between domestic and external financial prices, but at the same time, expose the domestic financial system to shocks of wider variety (e.g., external as well as domestic shocks) and of greater magnitude and frequency.

A feature more unique to cross-border flows is that they generally involve different sovereign states that have different political and economic systems and have governments that may pursue different macroeconomic policies. Thus, in a liberalized environment,

  • Cross-border flows for a given country are influenced not only by the policies and conditions in that country, but also by policies and conditions in other countries, since asset allocation decisions are based on comparing the universe of risk-return profiles available in all countries. Consequently, domestic (monetary) authorities have less influence over financial transactions in an open economy than in a closed one, and thus are more constrained in their conduct of macroeconomic policies.

  • In addition to magnifying certain traditional types of risk, cross-border flows introduce risks such as foreign exchange, transfer, and settlement risks that did not exist or were of limited importance in the domestic market. Moreover,

    • —Recent technological advances notwithstanding, collecting and analyzing information could still be costly and difficult for external transactions, and thus subject the value of investment to greater uncertainties.

    • —Cross-border transactions could be subject to different legal rights and obligations than those that apply to domestic transactions and may also differ in, or lack, an enforcement mechanism.

    • —Interlocking claims and liabilities through the interbank markets, over-the-counter derivatives transactions, and the payment and settlement systems become more complex. Since typically more than one geographical area and jurisdiction are involved in cross-border transactions, and the number of intermediaries involved is much larger than in the domestic context, the risks involved are more complex.4 Because these systems are interdependent, a disturbance in any one of them has the potential to affect the others significantly. Cross-border payment and settlement arrangements thus become an important channel through which contagion risks can manifest themselves across borders (Crockett, 1997b).

    • —Regulatory and supervisory regimes could differ among countries and permit circumvention of domestic regulation and supervision. Such differences may create incentives for capital to flow across borders to countries, including offshore financial centers, with inadequately regulated and supervised financial markets. This militates against effective supervision and regulation of financial institutions and transactions.

    • —Perhaps most important for stability, an open system provides an avenue for capital outflows including capital flight by residents, which could represent a leakage that is not recycled back into the system. A closed financial system (with an appropriate market structure and institutions), by contrast, has a self-stabilizing mechanism since funds that are withdrawn from one market or institution must necessarily be reinvested somewhere else, and, hence, asset prices and distribution of liquidity adjust correspondingly to absorb the shocks,5 assisted by the central bank to recycle liquidity and act as a lender of last resort to stabilize the system in the event of incipient crisis.6

Implications of Capital Mobility for Domestic Financial System Stability

The characteristics described above present implications that go beyond those encountered in domestic financial liberalization. Some of these are beneficial to stability, while others present risks. Much like domestic liberalization, capital account liberalization is about maximizing the benefits while limiting the risks and costs.

Benefits of Capital Mobility for Financial System Stability

Capital mobility can have a positive impact on financial stability in a number of ways:7

  • Efficiency and strength. First, free capital movements contribute, both domestically and worldwide, to efficiency of the financial system and the development of financial markets, and ultimately a more profitable and stronger financial system. It provides greater scope for markets to achieve a more efficient allocation of financial resources and help channel resources into their most productive uses. A closed capital account is often synonymous with a regulated and underdeveloped domestic financial market and is used to protect inefficient domestic institutions and/or support financial repression.8 Over the longer run, such a system tends to lead to a slow decay in the economy and consequent deterioration in the health of the financial system and, ultimately, to a loss of financial and economic stability.

  • Liquidity and smoothing of cycles. Second, mobility of capital improves the menu of investment outlets available to suppliers of financial funds and offers end users (governments, domestic corporations, etc. in the receiving countries) access to cheaper and more sophisticated financing by increasing the potential pool of investable funds. It may contribute to financial stability by easing liquidity constraints (for financial and nonfinancial institutions) particularly at times of market stress. By allowing households and firms to borrow abroad when incomes are low and repay when they are high, capital mobility may help smooth consumption and investment and thus dampen business cycles.

  • Risk diversification and resilience to shocks. Third, by expanding opportunities for portfolio risk diversification among alternative assets, it enables investors to diversify risks associated with disturbances that impinge on the home country alone. Companies can protect themselves against cost and productivity shocks by investing in several countries across which such shocks are imperfectly correlated and, thus, against the impact of the difficulties that could otherwise affect the domestic financial system. The presence of strong foreign banks could help to maintain crucial settlement and other banking functions when domestic institutions are incapacitated by loss of credibility. For the capital-importing country itself, larger markets for the country’s assets may stabilize asset prices if the shocks that affect domestic demand for these assets are negatively correlated with those that affect foreign demand for them.9

  • Market discipline encouraging better policies and management. Fourth, investors are no longer captive in a country. Their ability to move funds across borders in search of higher yields or to find higher security in response to deviations from consistent macro-economic and financial policies imposes greater market discipline. This encourages better macroeconomic management on the part of the domestic policymakers, as well as better risk management by individual corporations or financial institutions; this in turn reduces the risk of future financial problems.10

  • Removal of distortions associated with controls. Fifth, in a world of highly developed financial markets, allowing greater capital mobility would help avoid a number of problems associated with restrictions on capital movements. With the growing difficulties of enforcement, policies designed to limit international capital movements will have to be increasingly comprehensive, and thus distortionary, to ensure effectiveness (see below). Such policies may impede smooth functioning of financial markets, lead to a loss of the efficiencies that derive from liberalized markets, and may eventually end up unduly restricting desirable transactions, including hedging against financial risks. Moreover, attempts to circumvent the existing controls can heighten risks to the financial system by directing flows via channels that are less well regulated, such as offshore financial center11 and other unregulated activities (e.g., nondeliverable forward markets) and, as such, can distort the allocation of financial resources and cause disintermediation in the domestic financial system.

Risks Associated with Capital Mobility and Implications for Financial Stability

Despite the benefits associated with the liberalization of capital movements, experience from emerging markets and industrial countries in recent years also suggests that these benefits are not automatic and that potential risks to financial stability can be substantial. As world financial markets have become increasingly integrated in the last two decades, numerous banking sectors have experienced episodes of instability. Some of these episodes culminated in full-fledged banking and currency crises, which have raised questions about whether increased capital mobility has been responsible for the proliferation of financial crises.

In a recent survey paper that reviewed experience with financial liberalization and its linkages with financial crises in about 35 economies, Williamson and Mahar (1998) found that of the 24 sample economies that had experienced financial crises following financial sector liberalization, 13 economies had liberalized their capital account within five years prior to the crises (Table 14.1).12 The survey also provided evidence that in 9 out of 14 severe financial crisis episodes, net private capital inflows had increased, exceeding a threshold level of 3 percent of GDP, in the two to four years leading up to the crisis or during the crisis itself. Moreover, the inflows were reversed, with the ratio during the crisis year falling by over 35 percent from the average value during the two years before the crises in half of the episodes, and in 11 out of 14 cases, the ratio of the stock of short-term debt to exports had exceeded at least 30 percent. This evidence may suggest that increased capital mobility may be a contributing factor in explaining financial crises, potentially impacting financial system stability through two main and often interrelated channels: by posing risks to macroeconomic stability and by creating an opportunity for financial institutions to mismanage their financial risks. Initial shocks to a system can propagate themselves more widely to other countries through systemic linkages and contagion.

Table 14.1.Capital Account Liberalization and Financial Crises
Country (first year of financial difficulties)Capital InflowsLiberalization Within Five Years Prior to Crisis
Short-termPortfolio
Severe crisis1
Argentina (1980)OpenOpenYes
Argentina (1989)ClosedClosedn.a.
Argentina (1995)OpenOpenYes
Chile (1981)OpenOpenYes
Mexico (1994)OpenOpenYes
Venezuela (1994)ClosedClosedn.a.
Malaysia (1985)OpenOpenNo
Philippines (1981)ClosedClosedn.a.
Thailand (1997)OpenOpenYes
Indonesia (1997)(Relatively) openOpenYes
Korea (1997)(Relatively) openOpenYes
South Africa (1985)ClosedOpenNo
Turkey (1985)OpenClosedNo
Turkey (1991)OpenOpenYes
Less severe crisis2
United States (1980)OpenOpenNo
Canada (1983)OpenOpenNo
Japan (1992)OpenOpenNo
France (1991)OpenOpenYes
Italy (1990)OpenOpenYes
Australia (1989)OpenOpenYes
New Zealand (1989)OpenOpenYes
Brazil (1994)ClosedClosedYes
Indonesia (1992)(Relatively) openOpenYes
South Korea (mid-1980s)ClosedOpenYes
Turkey (1994)OpenOpenYes
Sri Lanka (early 1990s)ClosedOpenYes
Source: Williamson and Mahar (1998), with some modifications.

Countries that experienced bank runs or other substantial portfolio shifts, collapses of financial firms, or other massive government recapitalization are recorded as severe crisis countries (as classified in Lindgren, Garcia, and Saal, 1996).

Countries that experienced extensive unsoundness in the banking system short of a full-blown crisis are recorded as less severe crisis countries (as classified in Lindgren, Garcia, and Saal, 1996).

Source: Williamson and Mahar (1998), with some modifications.

Countries that experienced bank runs or other substantial portfolio shifts, collapses of financial firms, or other massive government recapitalization are recorded as severe crisis countries (as classified in Lindgren, Garcia, and Saal, 1996).

Countries that experienced extensive unsoundness in the banking system short of a full-blown crisis are recorded as less severe crisis countries (as classified in Lindgren, Garcia, and Saal, 1996).

Macroeconomic Stability Risks

Macroeconomic stability risks stem mainly from the large size of potential flows relative to the ability of authorities to offset the possibly adverse influences and the capacity of economies to absorb or adjust to such flows; the resulting risk of asset price misalignments and macroeconomic instability could in turn result in financial system instability. Destabilizing influence on the financial system could come from either excessive inflows or sudden large outflows.

Risks Associated with Inflows

Large capital inflows may lead to excessive expansion of domestic demand, which is likely to be reflected in inflationary pressures, real exchange rate appreciation, and a widening of current account deficits.13 They typically result in a rapid credit expansion14 that could reflect a number of different routes. For example, inflows are often mediated through the domestic banking sector and thus directly contribute to credit expansion. More indirectly, monetary policy may become expansionary due to unsterilized intervention to prevent nominal exchange rate appreciation, with similar results.

Overheating will eventually lead to a downturn in the economic cycle that will result in a deterioration of the quality of bank assets. The adverse impact on the financial system is especially serious when the overheating triggers an asset price bubble, followed by a collapse during the downturn.15 While an early recognition of overheating could in principle prompt foreign investors to reduce investments and thereby help quench the overheating, a number of factors could contribute to a buildup of an unsustainable increase in asset prices and credit growth. These include delay in recognition of macroeconomic imbalances and unwarranted optimism on the part of investors, loose monetary policy and asset diversification needs in creditor countries, and belief in the implicit guarantee for the recipient country’s banking system. Capital importing countries have limited or no control over many of these potential sources of vulnerability.

The buildup of inflows is likely to be more pronounced if, in addition to external factors, the domestic macroeconomic policy mix, which the authorities do have more control over,16 provide strong incentives for inflows. International capital flows tend to be highly sensitive to the incentives created by the macroeconomic policy mix, and the liberalization of the capital account brings more sharply into focus inconsistencies in monetary, exchange rate, and fiscal policies. As experienced by many countries in the 1990s, tight monetary policy to pursue disinflation goals under fixed or tightly managed exchange rates, often with insufficient support from fiscal policy, generates strong incentives for short-term, speculative inflows. Perceptions of low or negligible exchange rate risk encourage (short-run profit-motivated) foreign investors to take advantage of interest rate differentials, and residents to raise funds from abroad at lower interest rates.

Indeed, inconsistent macroeconomic policy mixes of this sort have been the driving force behind the buildup of external liabilities in many cases. Often, policies were clearly unsound and unsustainable, typically with a large fiscal deficit that remained uncorrected and monetary policy bearing much of the burden of keeping inflation in check and attracting capital to finance current account deficits. In some other cases, however, the unsustainability of policies were less obvious, in that fiscal policies remained reasonably tight and current account deficits largely financed private sector investment. What was not properly recognized was the nonproductive nature of these investments, which set the ground for future problems.

Risks Associated with Sudden Outflows

Episodes of excessively large inflows are more likely than not to end with sudden large reversal of flows, particularly when the inflows were induced by short-run returns, and to precipitate a financial crisis. Sudden reversals of flows can occur when perceptions and sentiments change and compound the problems in the financial sector that had already been weakened by the large inflows. Such sudden large-scale outflows more than anything else were at the heart of many financial crises. These reversals usually entail heavy speculative attacks on domestic currencies. Loss of confidence in domestic currency and the high volatility of exchange rates may raise uncertainty and trigger bank runs, as depositors and creditors leave the domestic banking system owing to the expectation of exchange rate depreciation and the concerns of weaknesses in banks and nonbanks that may reflect asset price changes. If there is a run on foreign currency deposits, the central banks’ ability to act as a lender of last resort is limited by the availability of reserves and may result in bank failures. Even when there are no bank runs, the increase in interest rates to defend the currency and the sharp decline in economic activity that often accompany currency crises weaken the repayment capacity of bank borrowers, sharply deteriorating banks’ asset quality and their liquidity and solvency. The resulting financial problems tend to be much more severe than would be expected in a typical cyclical downturn. Banking and currency crises often feed on each other, culminating in severe financial crises.17

While the swings in perceptions are almost always rationally based (i.e., starting as rational reactions to policy mistakes or external shocks), they may on occasion be excessive, and may sometimes reflect contagion effects that may be the result of incomplete information, herd behavior, or inaccurate appraisal of the underlying economic situations (see Fischer, 1997). Economic literature also illustrates the possibility of multiple equilibria, in which, after large shifts in prices, the economy becomes trapped in a “bad” equilibrium and what were previously good assets become nonproductive.18

As we have seen on numerous occasions, regardless of their underlying source, excessive swings in market sentiment and resulting changes in key financial prices are a major source of risk to the financial system. This could be particularly relevant for small emerging markets that have not established a stable investor base and whose financial sector is small relative to the capital flows involved.19

Mismanagement of Financial Risks

Greater freedom of capital movements introduces additional risks to financial stability also through the increased possibility of mismanagement of risks by individual institutions, particularly financial ones. As noted above, cross-border activities of banks and nonbank entities introduce specific risks that may increase the magnitude, or complicate the management, of the types of risks that banks more typically encounter in their domestic activities.20 Many of these risks relate to the use of foreign exchange associated with cross-border borrowing and lending (including transfer, sovereign, country risks, and increased exposure to interest rate, foreign exchange, and liquidity risks), but some arise from differences in other institutional arrangements. In some cases, these risks may not be adequately regulated or supervised due to jurisdictional limitations on the part of regulators and supervisors (e.g., in foreign branches and subsidiaries). An overview of the main risks that arise in the context of an open capital account and examples of specific cross-border transactions that may contain such risks are provided in Table 14.2. Additionally, as in the domestic context, implicit or explicit guarantees, most typically of deposits, introduce moral hazard and encourage excessive risk taking. The added twist under external capital mobility is that the fiscalization of losses in the banking system may cause the government’s creditworthiness to deteriorate much faster. To the extent that the government assumes both external and foreign currency liabilities as a means to restore confidence in the financial system, this will strain its sovereign external debt-servicing capacity, even triggering a sovereign debt crisis.

Table 14.2.Various Types of Risks Involved in Cross-Border Capital Movements
Type of RiskDefinitionType of International Capital Transactions

Subject to Such Risks
Credit riskThe failure of a counterparty to perform according to a contractual arrangement. It applies not only to loans but also to other on- and off-balance-sheet exposures such as guarantees, acceptances, and security investments. Additional dimensions of credit risk in the context of cross-border transactions include:

  • Transfer risk: when the currency of obligation becomes unavailable to the borrower regardless of its financial condition;

  • Settlement risk: risk in the settlement of some foreign exchange operations due to time zone differences;

  • Country risk: risk associated with the economic, social, and political environment of the borrower’s country.

Examples include

  • Bank lending to residents and nonresidents in foreign currency;

  • Banks’ onlending of their own foreign currency borrowing from abroad locally in foreign currency;

  • Bank involvement in derivative activities in foreign exchange (swaps, options, forwards, etc) with residents and nonresidents (including offshore counterparts); and

  • Bank involvement in other off-balance-sheet activities involving contingent liabilities or assets in foreign exchange (e.g., guarantees, acceptances, and security investments).

Market riskRisk of losses in banks’ on- and off-balance-sheet positions arising from movements in market prices that change the market value of an asset or a commitment. This type of risk is inherent in banks’ holdings of trading portfolio securities, financial derivatives, and open foreign exchange positions and in interest-sensitive bank assets and liabilities.Examples include

  • Foreign exchange risk

  • Interest rate risk

  • Risk involved in derivative transactions

Foreign exchange riskRefers to the risk of losses in on- or off-balance-sheet positions arising from adverse movements in exchange rates. It tends to be most closely identified with cross-border capital flows. Banks are exposed to this risk in acting as market makers in foreign exchange by quoting rates to their customers and by taking unhedged open positions in foreign currencies.Examples include

  • Banks’ market making in spot and forward exchange markets

  • Banks’ taking unhedged open positions in foreign currencies, e.g., through:

  • —Bank borrowing from abroad, or

  • —Banks’ onlending of foreign currency funds as domestic currency loans to residents or nonresidents

  • Banks’ derivative activities in foreign currencies

Interest rate riskRefers to the exposure of a bank’s financial condition to adverse movements in interest rates, arises as a result of a mismatch (gap) between a bank’s interest-sensitive assets and liabilities, and affects both the earnings of a bank and the economic value of its assets, liabilities, and off-balance-sheet instruments. Excessive interest rate risk may erode a bank’s earnings and capital base. The primary forms of interest rate risk are

  • repricing risk: arises from timing differences in the maturity and repricing of bank assets, liabilities, and off-balance-sheet positions;

  • yield curve risk: arises from changes in the slope and shape of the yield curve;

  • basis risk: arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics; and

  • optionality risk: arises from the express or implied options imbedded in many bank assets, liabilities, and off-balance-sheet portfolios.

Examples include

  • Banks’ holding of interest-sensitive domestic and foreign assets and liabilities, including off-balance-sheet items.

Risk in derivative transactionsDerivatives are an increasingly common method of taking or hedging risks. The actual cost of replacing a derivative contract at current market prices is one measure of a derivatives position’s exposure to market risk. Since many of these transactions are registered off-balance sheet, supervisors need to ensure that banks active in these transactions are adequately measuring, recognizing, and managing the risks involved.Examples include

  • interest and foreign exchange rate derivative transactions (swap, options, forward, futures, etc) of residents with other residents and nonresidents.

Liquidity riskArises from the inability of a bank to accommodate decreases in its liabilities or to fund an increase in its assets at a reasonable cost. Inadequate liquidity affects profitability and, in extreme cases, can lead to insolvency. In the case of cross-border transactions, there is an additional foreign exchange liquidity risk that may arise from

  • a sudden interruption to banks’ access to foreign funding;

  • absence, in general, of a lender-of-last-resort facility by the central bank for foreign exchange transactions; and

  • a sudden dry-up in foreign exchange markets during periods of tensions to convert domestic currency into foreign currency.

Examples include
  • banks’ lending to residents and nonresidents in domestic and foreign currencies; and

  • banks’ borrowing from abroad.

Risk-related problems can emerge in many ways. The Latin American debt crisis of the 1980s highlighted the country risks of sovereign bank lending that were insufficiently appreciated and led to large exposures by banks in industrialized countries that could have had systemic consequences. More recently, the Asian crisis illustrated the liquidity risks involved in short-term external funding by banks. Initial attempts in Korea by the central bank to act as a lender of last resort with respect to foreign currency funding quickly depleted international reserves and the ability of the authorities to provide such support. The large growth in short-term flows was also encouraged by insufficient recognition of credit risk on the part of creditor banks. It is argued that regulatory treatment of the risks of short-term interbank loans may also have contributed to unwarranted growth in exposure.21

Weakness in risk management becomes a lethal brew when mixed with macroeconomic instability. Just as domestic financial crises have typically occurred as a product of a boom-bust cycle fed by financial system excesses, capital flows can sharply amplify the vulnerabilities of a weakly supervised financial system. The recent experience in Asia is a case in point. In that region, capital inflows into the banking sector helped fuel rapid credit expansion, with banks being increasingly exposed to credit and foreign exchange risks and to maturity mismatches in foreign currencies. Banks’ foreign currency lending to corporate borrowers that did not have secure foreign exchange income streams subsequently created major problems once the currencies started to depreciate. More generally, rapid growth of assets also strained banks’ capacity to assess risk adequately. The weaknesses in the regulatory, supervisory, and incentive systems in these crisis countries were aggravated by the implicit exchange rate guarantees provided by their pegged or tightly managed exchange rate regimes and high interest rate differentials.22

International Linkages and Contagion

Capital mobility and increased financial integration could also facilitate the spread of financial crisis. One early recognition of the potentially serious ramifications of global financial transactions emerged upon the collapse of Herstatt Bank in 1974, leading to the creation of what became the Basel Committee on Banking Supervision. Successive crises since then have further illustrated the importance of international financial operations as channels through which disturbances could be transmitted across borders.23

The series of crises in the 1990s—in Europe, Latin America, Asia, and Russia—demonstrated the importance of contagion effects in transmitting disturbances. Contagion is an inherent characteristic of the financial system. Since financial decisions are forward looking, any event in a market, borrower, or instrument causes investors to reevaluate their assessment of markets, borrowers, or instruments, in particular of those that may share some of the characteristics of that market, resulting in portfolio reallocation decisions. Changes in wealth of investors caused by a rise or fall in prices of assets will also prompt reallocation of portfolios. Additionally, within an interlocking financial system, failure of one institution will end up in losses being shared by its counterparties. What has been more striking is the severity with which the financial market of an economy was affected.

The discussions so far have focused on the effects of capital movements on a country’s financial system. But the relationship also goes in the other direction. The stability of a country’s financial system affects not only capital flows involving that country, but also may ultimately influence financial stability in other countries through the swings in flows. In the Asian crisis, the malaise of financial institutions in Japan, a major creditor, probably contributed to the large swings in credit by Japanese banks that in turn likely amplified the severity of the crisis in Asian countries. Lack of appropriate control over counterparty risk by major international banks allowed Long-Term Capital Management (LTCM), a nonregulated financial entity, to take on excessive risks, and eventually triggered a series of events that dried up liquidity in many markets and risked a global financial crisis. In the latter case, the high degree of leveraging contributed to the magnification of funding risk, asset liquidity risk, and market risk.24

Implications for Different Countries

Recent discussions on financial system stability and capital mobility have chiefly focused on emerging market economies, but the linkage between capital mobility and financial system stability is important for all countries. No group of countries, either large or small, industrialized or developing, net creditor or debtor, has been immune from crisis. While capital mobility may not have been a major factor in some crises, the risks and vulnerabilities that could emerge from capital mobility are relevant for any country with an open capital account.

Macroeconomic vulnerabilities can arise in any country, although larger economies with a relatively smaller external sector could have greater control over the macroeconomic policy mix than the smaller countries and may face less of a dilemma. Mismanagement of risk is a threat in all countries. Here, individual institutions in industrialized countries with sophisticated markets tend to have better risk management, but the complexity of markets is greater and there are greater possibilities for excessive risk taking that may go unnoticed, and greater incentives for risk taking also arise from the high return on equity expected of financial firms. Also, concentration of interlocking claims reflecting, in part, consolidation of financial firms is a feature of mature markets, and this could have significant consequences, particularly when it involves major financial centers. Contagion is also an issue, and these issues appear to have a more severe impact on emerging markets.

There is little empirical work from which to draw definitive conclusions as to the relative importance of capital mobility in causing, limiting, or preventing financial system instability. Nonetheless, Table 14.1 suggests that financial crises in industrialized countries have been less severe, and they also seem to have been spared the more serious problems of simultaneous banking and currency crises. This may have been due to the fact that these economies were somehow less vulnerable in some or all of the above aspects, but it could also have been that other factors, such as the overall creditworthiness of a country, helped to contain the crisis. In this connection, once a financial crisis becomes open, governments have typically extended guarantees to at least some creditors of the system to restore stability. The credibility of such guarantees depends on the sovereign’s creditworthiness and the currency’s continuing convertibility. In this aspect, emerging markets that lack an established track record of credibility would be more vulnerable.

Recent episodes indicate that emerging markets that are net debtors are most at risk from volatility in capital flows. For these countries, avoiding sudden and large reversals of flows should have a high priority, since such reversals can trigger very severe crises and impose most heavy costs. Industrialized countries, particularly creditor countries, seem less prone to deeper crisis, as noted above, but their financial crises can lead to a reversal of capital flows, which can have serious consequences on other countries, especially emerging and developing economies. Smaller economies that are financial centers and predominantly intermediate international flows, including offshore financial centers (OFCs), may face little immediate cost in terms of their own financial system, apart from a possible effect on income and employment gained from these activities. But they have an important role in systemic stability in that they could affect other countries if shortcomings in prudential regimes and other institutional framework magnify risks in the global system.25

Systemic Responses

The severity of financial crises in recent years has prompted many to ask what can be done to minimize the likelihood and severity of future crises. Attention has focused on the role of capital flows in these crises and the steps that may be taken to minimize the risks such flows entail for financial system stability.

The analyses in the previous section of the possible channels through which capital mobility may present risks to the financial system offer hints as to what may be done to limit the risks and vulnerabilities. These systemic responses include better macroeconomic policy framework; policies to improve risk management, including prudential policies and other supporting reforms; and an internationally coordinated effort to limit systemic transmission and contagion. Restrictions on capital movements attempt to directly influence flows and thereby reduce macroeconomic and prudential risks. Many of the responses discussed below are being implemented or debated by the international community.

Macroeconomic Policy Framework

Prudent macroeconomic policies are a fundamental requisite for financial stability. As we discussed above, a liberalized capital account can accelerate and aggravate the problems caused by inconsistent domestic macroeconomic policies. An unsustainable macro-economic policy mix and the resulting loss in confidence have led to sharp capital outflows in many cases. Recent experience has also highlighted the need for a consistent monetary and exchange rate policy mix that avoids creating incentives for potentially destabilizing short-term capital flows. In a liberalized regime, monetary policy can target exchange rates or interest rates, but not both. This consistency, moreover, must prevail not only at a point in time, but also over time. A pegged or tightly managed exchange rate regime can become “time inconsistent” if the decision to maintain the level or range of the exchange rate set in the past is no longer optimal under the prevailing conditions. In that case, private decision makers would distrust policy announcements defending a peg and adjust their behavior accordingly, including through speculative attacks.

Prolonged maintenance of pegged or tightly managed exchange rate regimes in many Asian economies26 not only complicated the monetary policy response to the overheating pressures associated with the large capital inflows, but also led market participants to largely ignore exchange rate risk. This created a situation where investors and creditors began to question the sustainability of the regime. Currency and maturity mismatches arising from intermediation of the inflows created financial sector vulnerabilities that resulted in a reassessment of creditworthiness. Moreover, rising nonperforming loans and, in some countries, large real estate exposure meant that when capital flows were reversed, interest rate defense was difficult to use aggressively and was not seen as credible. Reliance on intervention and (in Korea) the use of reserves to honor maturing commercial banks’ foreign currency borrowings depleted usable reserves and made the maintenance of fixed exchange rates untenable, forcing an exit from the fixed regime.

One possible element of a strategy to establish credibility in the sustainability of the policy mix would be for countries either to have a very strong commitment to the pegged exchange rate—e.g., through currency board arrangements (CBAs) or monetary unions—or to choose a flexible exchange rate policy from the outset that reduces the need for such sustainability on the exchange rate front.27

As capital account liberalization has progressed, a number of countries have responded to the increase in capital flows by adopting greater exchange rate flexibility.28 Such moves to greater exchange rate flexibility were motivated by the recognition that the greater exchange rate uncertainty of a flexible regime would, by eliminating the implicit exchange rate guarantees provided by pegged regimes, discourage volatile capital flows that target short-term returns. Furthermore, flexibility in exchange rates would not only discourage banks and nonbank institutions from taking excessive unhedged foreign exchange positions, but would also encourage the development of the foreign exchange market as market participants seek to hedge exchange rate risks.

Adoption of CBAs has often been motivated by the desire to import credibility to the exchange rate regime and was usually an element of a broader stabilization strategy after a crisis. Monetary union, as in European Monetary Union, has a far broader political and economic dimension. In either case, there seems to have been a less direct link between specific capital flow management objectives and the adoption of such arrangements.

Both a flexible exchange rate regime and a CBA (or monetary union) would help reduce the risks of a sudden, large-scale outflow. A flexible regime does so by introducing foreign exchange risk to investors and, hence, reducing the amount of short-term, return-targeted inflows, while a CBA (or monetary union) makes a devaluation very difficult to implement, which can help reduce the risk of potential sudden outflows that may arise out of an expectation of a devaluation.29 However, neither solution eliminates the potential financial sector vulnerabilities that arise when investors’ confidence in the recipient country’s economy induces large inflows that are not matched by financial institutions’ capacity to intermediate them efficiently, nor do they eliminate the possibility of large outflows itself when investors lose confidence in an economy. In terms of financial system vulnerabilities, it has also been pointed out that vulnerabilities of the banking system to incipient runs, when they occur, may increase in CBAs that lack sufficient capacity to act as a lender of last resort (see Baliño and Enoch, 1997).

The maintenance of a consistent macroeconomic policy mix also requires institutional support in other areas. Especially with respect to monetary policy, increased capital mobility alters the effectiveness of different policy instruments in achieving the objectives of monetary policy (see Johnston and Sundararajan, 1999). Instruments that impose high costs or administrative constraints on banks (interest rate or credit ceilings or high unremunerated reserve requirements) may be circumvented more easily by disintermediation through the capital account, and thus become less effective. Monetary instruments that operate on the overall cost of money and credit in financial markets may be transmitted more rapidly to credit and exchange markets and allow the central bank to influence the decisions of financial institutions and markets that operate in domestic currency, locally and internationally. Lack of adequate indirect instruments of monetary policy constrains the ability of the authorities to manage capital inflows and greatly complicates the implementation of monetary policy (as experienced, e.g., by Thailand during the heavy inflow episodes in the mid-1990s). Moving away from direct instruments of monetary control toward a more market-based approach (such as open market operations and central bank liquidity facilities at market interest rates) is thus a significant component of ensuring the conduct of appropriate and consistent monetary policies under greater capital mobility. Such a shift toward market-based monetary and exchange policy operations also requires parallel efforts to develop liquid money and exchange markets.

Prudential Policies

An appropriate macroeconomic policy framework is a necessary, but not a sufficient, condition to secure a sound financial sector. Mismanagement of risks, in particular by financial institutions, needs to be addressed to ensure financial stability. Financial and banking crises have taught us the lesson that vulnerabilities stem from weaknesses in management of financial institutions and in the structural environment in which they operate, which in turn encourage buildup of risks. These include poor management of financial institutions that result in undue risk taking; lack of adequate information failing to signal the problem; explicit or implicit guarantees encouraging excessive risk taking and weakening discipline; ineffective supervisory environment failing to counter perverse incentives and lack of market discipline; and concentration of ownership and connected lending, increasing the vulnerabilities (see Folkerts-Landau and Lindgren, 1998).

Given the nature of the problem, i.e., mismanagement of risks, the standard prescriptions that are offered in relation to preventing financial crises should apply with respect to the issues that are raised by greater capital mobility. Cross-border capital flows involve the same fundamental categories of risks as those encountered by financial institutions in their domestic transactions, though with added dimensions in each category. This basic similarity between the risks of capital transactions and purely domestic transactions means that these risks can be addressed within the overall prudential framework, by strengthening market discipline and by adopting and extending regulations and supervision used in the domestic financial market. Market discipline will be enhanced by enforcement of better disclosure standards, as well as by judicious design of safety nets and other policies that might distort incentives. Development and application of best practice prudential regulations would seek to ensure that institutions manage risks in a way that keeps an institution’s risk exposure within its ability to handle such risks. Such prudential regulations would include appropriate prudential limits against excessive risk taking involving cross-border capital movements; incorporating such risks in loan classification and provisioning requirements; adjusting risk weights in capital adequacy requirements for cross-border and off-balance sheet activities; enhanced monitoring through appropriate disclosure and reporting rules; and oversight of the institution’s capacity to assess and manage its own risk exposures (see Table 14.3 for specific rules and regulations).30

Table 14.3.Various Types of Risks in Cross-Border Capital Movements and Prudential Measures to Manage Such Risks
1. Credit Risk
  • Proper recognition, analysis, monitoring, and limiting of credit risk for domestic as well as cross-border exposures.

    • – Limits against large exposures to a single borrower or a group of related borrowers and against connected lending.

    • – Limits against credit concentration in particular industries, sectors, or regions, etc.

    • – Exposure limits for foreign currency loans.

    • – Application of risk weights to banks’ capital requirements that specifically reflect elements of cross-border risk and imposition of higher capital adequacy requirements for banks with large international business.

    • – Incorporation of various elements of cross-border risk (e.g., in foreign currency loans, offshore, derivatives, or other off-balance-sheet activities) in loan classification and provisioning requirements.

    • – Careful monitoring of banks’ foreign currency denominated or indexed loans to domestic customers that do not have adequate sources of foreign exchange or are otherwise unable to hedge the risks involved.

    • – Frequent disclosure requirements for banks’ cross-border activities.

2. Market Risk
a. Foreign exchange risk

  • Establishment of internal limits and monitoring mechanisms for foreign exchange exposure, including in off-balance-sheet transactions:

    • – net open foreign exchange position limits in specific currencies, including sublimits in spot positions and various forward maturities when derivative instruments are used, as well as on overall positions;

    • – specific capital requirements against foreign exchange risk; and

    • – adequate monitoring through disclosure of banks’ open positions in foreign currency and maturity profile of the outstanding contracts.

  • Ensure existence of instruments and markets for hedging foreign exchange risk;

  • Complement these prudential regulations with a consistent exchange rate and monetary policy mix that avoids explicit or implicit exchange rate guarantees to limit banks’ and other individuals’ tendency to misprice foreign exchange risk.

b. Interest rate risk

  • Enhanced monitoring and reporting requirements on the

    • – maturity structure of interest-sensitive assets and liabilities, broken down into several daily, weekly, monthly, and quarterly maturity “buckets” including the hedging instruments, if off-balance sheet

    • – maturity structure for each currency in which the bank has a substantive position since interest rate risk can be assumed in currencies other than the domestic currency; and

    • – the types of interest bearing securities and their maturity breakdown.

  • Active management of maturity mismatches between bank assets and liabilities, with limits established against such gaps and limits on various instrument exposures incurred by the bank.

  • Sensitivity analyses of bank balance sheets and off-balance-sheet positions under alternative scenarios for interest rate changes.

c. Risk in derivative transactions

  • Establishment of risk-management guidelines, internal control mechanisms for adequate measurement, and management of risks involved in derivative activities.

  • Incorporation of exposure to such transactions into the loan classification and provisioning requirements.

  • Bringing accounting rules in line with international standards to accurately measure the volumes and associated risks.

  • Frequent disclosure requirements for such activities, in particular on notional principal (the principal amount on which various payments associated with the derivatives are based) and actual cost of replacing the derivative contract at current market prices.

3. Liquidity Risk
  • Information disclosure by banks on their liquid assets, expected future cash flows, and liquidity gaps for specified future periods, and details of their liquidity management method, and by the central bank on market liquidity situation.

  • Establishment of limits against maturity mismatches in a prudentially based liquidity framework based on a maturity ladder.

  • When prudentially based liquidity framework is not in place, maintaining adequate level of liquid assets through, for example, appropriate liquid asset and/or reserve requirements.

  • Separation of management of liquidity risk within each currency component of a bank’s balance sheet and inclusion of off-balance-sheet operations in these limits.

  • Access to diversified funding bases in terms of sources of funds and the maturity breakdown of the liabilities, taking into account differences in volatility and reliability of domestic and external sources of liquidity.

Country experiences suggest that a strong prudential framework helps limit the risks that arise from external flows. While a more detailed empirical study is needed to draw firm conclusions, including the relative importance of macroeconomic and prudential policies, countries that have a strong prudential framework appear to have fared better in the crises of recent years.31

Prudential risk management should be fostered more broadly among economic sectors—households, nonfinancial firms, and government—in addition to such management in financial institutions and markets. Careful monitoring of risk exposures in the balance sheets of households, nonfinancial firms, government, and the financial system would help to ensure timely adjustment of policies and avoid buildup of risk exposures. For example, sound practices in debt and liquidity management, which take into account behavior of financial and corporate sectors, can help avoid buildup of vulnerabilities.32

However, it is also true that in terms of implementation, capital mobility brings additional dimensions that pose challenges to the effective application of prudential policies. Below, we shall discuss some of the issues that appear more pertinent.

Mismatch Between the Size and Complexity of Risks and the Ability to Manage Them

Development of risk management practices usually follows market development, and as long as the latter is gradual, the risks faced are usually within the bounds of historical experience. However, new transactions, including those that become possible when markets are opened to external transactions, pose the danger that institutions will engage in them without having adequate understanding of the risks involved or the ability to manage them.33 This issue is particularly relevant for developing countries and countries that have had a heavily regulated domestic market. Recent examples of shortcomings in risk management include the insufficient recognition of the risks involved in foreign currency domestic lending, rollover risks associated with short-term borrowings, and the risks involved in derivatives.

Increasing globalization also presents challenges in risk management for even the better established institutions in industrialized countries. Such risks sometimes arise in the context of new financial technologies such as derivatives, but also with respect to more traditional types of risks. The latter often surfaces when activities of foreign branches and subsidiaries are not well monitored and managed.34 Insufficient recognition of country risks also seems to have been a recurrent feature in international financial crises, causing a sudden reappraisal of risks and withdrawal of funds from debtor countries, as the nature of the risks involved expanded from the traditional sovereign and transfer risks to the broader risk of counterparty default arising from country-specific circumstances. Globalization also increases the size and number of transactions in foreign exchange markets, raising the scope of operational and settlement risks.

Lack of Information and Transparency, and Misjudgment by Creditors

Compounding the problem of insufficient risk appraisal is the relative lack of information about debtors that can cloud the assessment of risk by creditors engaged in cross-border transactions. Revelation of new and unexpected information could prompt the sort of sudden shifts in sentiment that have triggered numerous crises. Different or deficient accounting standards and legal regimes as well as other country-specific circumstances need to be taken into account in assessing credit and other risks, but a creditor may not possess the necessary expertise and may fail to understand or may ignore the additional element of risk involved until they become apparent for all. In the case of country risk, recent crises in Korea and Thailand also suggest that shortcomings in published international reserves data resulted in the market not fully recognizing a country’s vulnerabilities. Recent efforts to improve and harmonize international accounting and auditing standards, security market and financial institution disclosure standards, and the quality and transparency of economic data, including those on external assets and liabilities, will contribute significantly to addressing these problems.

In addition to disclosure of economic data, transparency about policy conduct can contribute to good governance and improved policy effectiveness, through well-informed public debate and reduced uncertainty in markets. From this perspective, the IMF has developed, in consultation with other institutions and national authorities, a set of disclosure and transparency standards: Code of Good Practices in Fiscal Transparency; Code of Good Practices on Transparency in Monetary and Financial Policies; Special Data Dissemination Standards; and General Data Dissemination System. The IMF has strived to promote adherence to these and other international standards and good practices through its technical assistance programs; new programs such as Financial Sector Assessment Program (FSAP), which uses the assessment of relevant financial sector standards as an input into broader assessments of stability and development needs; and Reports on Standards and Codes (ROSC), which compile summaries of standards and assessments prepared in different contexts (including FSAP). While openness about adherence to transparency standards seems a desirable objective, the balance between confidentiality and incentives for implementation on the one hand and assessment and public disclosure on the other hand is a key issue in designing incentives for adherence to various international standards.

Improving Supervisory Capacity and Regulations

The possible mismatch in risk-taking opportunities and risk management capacity underscores the importance of supervision. However, prudential regulations can be circumvented or unable to properly capture new types of risk, and effective supervision requires that authorities be able to monitor developments to identify emerging problems and respond flexibly to them. This will be a challenge to many developing economies. Assessment against international standards such as the Basel Core Principles (BCPs) on Banking Supervision will help supervisors identify their weaknesses, and implementation of these core principles and good practices will facilitate the strengthening of the prudential regime. However, supervision also requires human capacity to administer it effectively and will necessarily require accumulation of expertise and experience. Actual supervision is usually at best no better than the supervision practiced in private financial institutions in that country, so that risk of ineffective supervision will always be an issue, even in the most advanced financial markets with the best standards of supervision.35

Globalization of banking and financial activities that naturally accompany greater capital mobility also strengthens the need for effective consolidated supervision of financial entities. This in turn requires much stronger cooperation between national supervisory authorities. The emergence of large and truly international institutions poses tremendous challenges for supervisory authorities, as traditional home-host definitions lose relevance and the sheer size of those institutions and the diversity of their activities tax the authorities’ ability to supervise and regulate these mega institutions adequately.36

Appropriate regulations form the core of a prudential system, but as with any regulation, prudential regulations can have unintended consequences. Prudential regulations generally target the health of individual institutions, and concerns have been expressed that, while appropriate for that purpose, some regulations can have perverse effects on systemic stability. The potentially procyclical nature of capital adequacy rules have long been debated,37 and there has been a strong recent interest in the possible contribution that a low-risk weighting attached to short-term interbank exposure may have had on the buildup of these liabilities in the crisis countries.38 Different regulatory treatment across industries and in different countries can also encourage regulatory arbitrage and lead to concentration of risk in the most weakly regulated sectors and countries.

Systemic Transmission Issues and International Coordination and Cooperation

Other features of capital mobility and globalized markets are the speed at which shocks transmit internationally and the breadth of their repercussions. These have not only tended to magnify the size and severity of crises, but also made the response to crises much more difficult. As we have argued, emergency liquidity support during a crisis period may be severely constrained, and national authorities may simply not have the ability to stabilize the situation on their own, thus spreading the crisis to other countries. Stabilization of a situation, once it happens, will require a coordinated response by a number of countries that is hard to arrange in a short period of time. Different legal structures, such as whether bankruptcy rules are applied to domestic assets and liabilities or on a global basis, make the resolution of crises difficult. When the problem spills over into a sovereign debt problem, the resolution of crises is made difficult by the lack of an established mechanism to restructure sovereign bonds. These and other factors—including the global nature of portfolio allocation—tend to feed contagion.

Work is under way, in the private sector as well as among national authorities, to build a more resilient international monetary system, as well as to improve the response to an international crisis. Often, the efforts and debate revolve around measures to extend domestic mechanisms of crisis prevention and management to the global scene. In the foreign exchange settlement area, for example, a number of initiatives are being made to ensure payment-versus-payment for currency transactions. Supervisors have also stepped up cooperation in order to share information and respond to emerging problems with international dimensions in a timely manner. Discussions are continuing on how private sector involvement may be best secured to resolve financial crises (IMF, 1999a). There has also been a considerable debate on the role of the IMF as international lender of last resort.39 More generally, a number of international fora such as the FSF and the Group of 20 have been set up and activities of existing institutions such as the Basel Committee intensified to respond to the challenges.40 For example, the FSF Working Groups on Highly Leveraged Institutions (HLIs), OFCs, and Capital Flows (CF) produced reports at end-March 2000, which called for, among other things, a set of good practices for provision and sharing of timely information (OFCs), enhanced public disclosure by HLIs and enhanced risk management by providers of credit to HLIs, and improved data on aggregate external flows and positions (CF).41

It is also worth noting here again that greater capital mobility and integration also could help in ensuring financial stability. In addition to the largely theoretical arguments presented earlier, there are other concrete benefits. For example, well-run foreign-owned banks that are supervised effectively by a competent home supervisor could be immune from a crisis affecting domestically owned banks. Thus, they could help prevent capital flight in a crisis as depositors flee distressed domestic banks, and they also could continue to provide crucial banking and settlement services. Foreign ownership of industries may enhance private sector creditworthiness through the support from a parent company, and greater trade linkages could provide confidence about foreign exchange revenues that ensure external debt repayment and thus enhance confidence. More investment by foreigners generally, both direct and portfolio, raises the foreigners’ stakes in the stability and well-being of an economy and may make support from creditors easier to secure.

Capital Controls for Financial System Stability

The difficulties that may arise in putting up an adequate defense against crises have led to a reexamination of the possible role of capital controls in supplementing macroeconomic and prudential policies to safeguard financial system stability. While the evidence is still mixed, a recent study by IMF staff points to some tentative conclusions on the effectiveness of capital controls, and their application to prudential objectives (see Ariyoshi and others, 2000).

Capital Controls to Support Macroeconomic Policies

First, in terms of supporting macroeconomic policies, capital controls can, in theory, allow the pursuit of independent exchange rate and inflation objectives without exposing a country to large-scale inflows that could result in overheating or buildup of excessive external liabilities. However, country experiences show that for those countries that have substantially liberalized capital transactions, the ability of selective capital controls to provide monetary policy independence is limited. Controls can be circumvented quickly, particularly where financial markets are developed, and the corresponding impact on the exchange rate or the volume of capital flows also appear to be limited. On the other hand, capital controls could be more effective in a less liberalized and tightly managed capital account regime where the financial system is less developed.

Reimposition of capital controls also appears to be ineffective in preventing large-scale outflows that precipitate financial crises, especially when the reversals reflect unsustainable macroeconomic policies. When comprehensively applied and accompanied with necessary reforms and policy adjustments, it may be possible for outflow controls to provide a temporary breathing space in which to address weaknesses and to stabilize expectations. Nonetheless, some believe that the breathing space provided is often not used effectively and may be used to simply delay the implementation of corrective policies, which tends to increase the costs associated with the crises. Moreover, the imposition of controls could have a chilling influence on investor confidence and impose costs to the economy in terms of future access to borrowing or delay in the integration of the economy into global markets that offer longer lasting stability. Effective measures also risk discouraging legitimate transactions, including financial hedging operations to cover against various financial risks.

Capital Controls to Support Prudential Policies

The use of capital controls for prudential objectives has been debated mainly in the context of discouraging inflows, particularly of a short-term volatile nature, as well as to reduce the risk of excessive risk taking by intermediaries. For example, a number of countries have imposed taxes on inflows42 that were designed to impose a cost on short-term flows and encourage the lengthening of the maturity of external debt. Often, these measures were supplemented by more explicit measures that required a minimum maturity or credit rating for external borrowing. Other controls with a prudential element include provisions for the net external position of commercial banks and asymmetric open position limits that distinguish between long and short currency positions or between residents and nonresidents. The lengthening of the maturity profile improves the ability of countries to withstand shocks, and to limit the vulnerabilities from contagion. The rollover risks will be limited and the cushion that is provided will allow time for countries to introduce policies to strengthen confidence and, when there is an element of panic in investors, for the investors to settle down and reappraise the situation. There are some uncertainties as to the precise contribution of these taxes, but countries such as Chile appear to have been successful in lengthening the maturity profile of their debt, as reflected in its domestic statistics,43 while in some other countries controls seem to have been ineffective in this regard.

As far as short-term external borrowings by banks are concerned, effective prudential supervision should be able to contain the risks of short-term borrowing, so that capital controls of this type may not be necessary. However, where supervision is weak or borrowings by non-regulated entities or portfolio inflows are an issue, then inflow controls could play a role in reducing vulnerabilities created by short-term flows. However, experience shows that controls need to be broad-based and be adjusted continuously in order to prevent circumvention. Moreover, in a sophisticated market with a full range of derivatives instruments, transactions can be synthesized in any number of ways so that it will be virtually impossible to design a system of controls that is both effective and does not impose undue distortions (see Garber and Taylor, 1995).

Sequencing of Capital Account Liberalization and Supporting Policies

As noted earlier, countries that have recently liberalized or are in the process of liberalization have encountered financial system instability. In most cases, the weakness of supporting financial policies seems to have been an important factor. This underscores the importance of proper sequencing and coordination of various reforms and liberalization measures in the course of capital account liberalization. Prudent and sustainable macroeconomic policies need to be in place, and appropriate supervisory regimes and market infrastructure are, of course, most important. The conventional wisdom is that foreign direct investment (FDI) and longer-term flows should be liberalized first, and that liberalization of short-term interbank transactions should be carefully executed. This is because the requirements in terms of supporting policies to reduce the risks and manage potential volatility associated with flows are less stringent for FDIs and longer-term flows. As a result, in practice longer-term flows, particularly foreign direct investment, were liberalized early in many countries. This does not mean that shorter-term flows cannot be safely liberalized, if carefully accompanied by appropriate prudential safeguards and market development measures. In other words, while sequencing of liberalization measures is important, the putting in place and coordination of mutually supporting policy components that will contain the risks of liberalization are equally important to ensure successful and orderly liberalization—an observation that seems to be supported by the various country experiences (see Johnston and Sundararajan, 1999 for country experiences).

These broad principles notwithstanding, the actual sequencing itself is a complex issue involving case-by-case judgment of the specific country circumstances. While on conceptual grounds it may be desirable to have all the prudential policies and elements of market infrastructure in place before capital account is liberalized, this is not practical advice. The ability to manage risk and to supervise institutions and operate market-based instruments and institutions has a strong element of learning by doing. Unless institutions are allowed to engage in transactions, they will not be able to develop their ability to manage risks, nor will authorities be able to develop effective supervisory skills. It also must be recognized that, when a country is largely open to trade and has a developed financial system, it will be extremely difficult to maintain effective capital controls. Therefore, a strategy that involves initially a liberalization on the domestic front followed by external liberalization is also not feasible. Moreover, opening up of a market helps the development of that market as the wider range of participants brings both the skills and liquidity needed in market development. Thus, sequencing of liberalization, both externally and domestically, as well as with respect to supporting policies, is a dynamic and mutually reinforcing process.

The issues in the sequencing of measures to liberalize the capital account are to a large extent the same as those that confront domestic financial liberalization: how to strengthen monetary and financial systems and markets while maintaining macroeconomic stability. Thus, liberalizing capital flows can be seen as one aspect of a broader program of financial liberalization.

The literature on operational sequencing of different components of domestic financial liberalization identifies several principles to govern appropriate sequencing (see Johnston and Sundararajan, 1999).

  • Financial sector reforms that support or reinforce monetary policy and macroeconomic stabilization—e.g., reforms of monetary and exchange operations and public debt management, and related central banking reforms—should be given priority. In practice, steps toward market-based monetary arrangements and the associated central banking reforms have been implemented early in the reform sequence, because of the benefits for monetary control and the catalytic role central banking reforms play in fostering broader financial liberalization (see Alexander and others, 1995).

  • Financial sector reforms that are technically interdependent and that affect common policy goals have to be coordinated and implemented together to ensure policy consistency and credibility. This coordination typically requires that a critical mass of reforms be implemented together. For example, monetary and public debt management reforms and the associated reforms of money and government debt markets should be implemented together. Similarly, measures to introduce market-based instruments of monetary and exchange policy go hand in hand with measures to develop money and exchange markets, and the two sets of reforms are mutually reinforcing.

  • Monetary and exchange policy reforms should be closely coordinated with appropriate financial policy measures to support stability. Financial policies, particularly supervision and financial restructuring of banks, should be phased in to complement closely other financial reforms aimed at enhancing competitive efficiency, in order to help manage risks in liberalization and foster financial system stability. For example, the introduction of greater flexibility in interest rates and exchange rates through market-based instruments and exchange system liberalization necessarily requires, in addition to adequate market infrastructure, the adoption of prudential norms to manage market and liquidity risks that are tailored to the state of development of markets.

  • The pace and scope of liberalization should be adjusted to take into account the initial risk exposures in the financial and nonfinancial sectors—particularly the financial structure of nonfinancial firms. The initial conditions relating to debt-equity ratios, foreign currency exposures of nonfinancial firms, and the quality of bank loan portfolios and the pace with which bank restructuring and associated corporate restructuring can be phased in are the crucial elements in determining the pace of liberalization of financial prices and regulations.

  • The reforms that require adequate lead time for technical preparations, public consultations, and capacity building should be initiated sufficiently early to ensure the timely and effective completion of the overall reform program. For example, reforms of accounting and payment systems and other institutional and legal infrastructure typically require considerable lead time and should be initiated early to ensure effective implementation of prudential supervision and market development measures.

Given the different types of capital transactions that are undertaken by several sectors and their subsectors—government, financial firms, nonfinancial companies, and households—and the variety of control instruments that could apply to each, the potential mix and sequencing of measures to liberalize capital controls can be quite complex. Nevertheless, the principles already enumerated for the sequencing of financial liberalization can be usefully applied to the design and sequencing of capital account liberalization measures. Table 14.4 provides a mapping of capital account liberalization measures corresponding to the different stages of domestic financial liberalization discussed in the literature.44 The table also highlights additional prudential safeguards that will enable smooth implementation of capital account measures.

Table 14.4.Capital Account Liberalization During Various Stages of Financial Sector Reform
Stage 1: Preparatory
Domestic Financial Sector Reforms

In the initial stages of interest rate liberalization, when direct controls on credit and interest rates dominate, capital markets remain underdeveloped, the focus is on limited liberalization of interest rates—e.g., interbank interest rates, accompanied by the introduction of some key prudential norms, initiation of on-site and off-site supervision, and a minimal program of financial restructuring of banks and nonbanks—that helps to remove the impediments (and manage initial risks) from interest rate flexibility.
Capital Account Reforms

  • Liberalize selectively foreign direct investment.

  • Liberalize commercial, trade-related credit operations, guarantees, and financial backup facilities to facilitate trade liberalization and export promotion, and current account convertibility.

Additional Prudential Safeguards Encourage active management of both domestic and foreign currency liquidity by banks, if needed, through simple prudential norms, such as limits on positions.
Domestic Financial Sector Reforms

Direct controls on credit begin to be phased out; simple market-based instruments of monetary and exchange policy are introduced; market liquidity is managed actively through discount window and open market-type operations; basic infrastructure of money and exchange markets—market makers, settlement arrangements—begin to be established. A range of reforms is introduced to strengthen prudential supervision and regulation of banks, accounting reporting, and transparency arrangements; some financial restructuring of banks and nonbanks is completed as part of a broader bank restructuring strategy.
Stage 2: Initiating Market Development

Capital Account Reforms

  • Liberalize controls on inflows and outflows relating to money market transactions, particularly those of banks, as a way to foster and integrate interbank money and exchange markets.

  • Liberalize selected derivative transactions—on forwards and futures—to facilitate the hedging of commercial risks.

  • Liberalize controls on inflows relating to selected capital market instruments, particularly long-term private sector debt, and equity securities, including portfolio investments in banks and nonfinancial firms of high standing, to help maintain reasonable balance of debt and equity finance in nonfinancial firms and help raising of capital by banks.

  • Liberalize holding of bank deposits and purchase of specified assets abroad for eligible nonfinancial firms.

Additional Prudential Safeguards

  • Establish and force prudential limits on net and gross positions by currency and maturity buckets of foreign assets and liabilities of banks, and introduce appropriate risk and liquidity management guidelines for foreign exchange operations.

  • Strengthen risk management and internal controls of foreign exchange reserve management by central banks.

  • Strengthen accounting and disclosure standards for nonfinancial firms.

  • Identify and remove any biases in favor of debt or equity finance in tax and regulatory regimes.

Domestic Financial Sector Reforms

Money markets and secondary markets in government securities are strengthened through supporting reforms of institutional arrangements and payment systems; open market operations become more active; foreign exchange markets become deeper; central bank manages money market liquidity at its own initiative, and interest rates are fully flexible. Comprehensive bank and enterprise restructuring are pursued systematically; security market regulations are strengthened, including in money and government security markets. Financial risk management is fostered in all segments of the financial and payment systems, including in government debt and liquidity management.
Stage 3: Strengthening Financial Markets

Capital Account Reforms

  • Phase in liberalization of controls on both inflows and outflows of capital market instruments, money market instruments, and collective investment vehicles for financial institutions (including banks and capital market institutions) and eligible nonfinancial firms.

  • Selected liberalization of outflows to institutional investors.

  • Selected liberalization of inflows and outflows on real estate and other real asset transactions to facilitate asset management and loan recovery, etc.

  • Allow nonresident investment in government securities markets.

  • Liberalize remaining controls on derivatives and other risk management instruments for financial institutions and eligible nonfinancial firms.

Additional Prudential Safeguards

  • Strengthen risk management in all financial firms, by requiring adherence to standards of risk measurement and control.

  • Implement BCPs.

  • Strengthen risk monitoring and controls in government debt and liquidity management.

  • Where needed, expedite bank and enterprise restructuring, supported by appropriate arrangements for loan recovery and asset management.

  • Implement standards, core principles, and good practices in payment systems, securities regulation, insurance supervision, and money laundering.

  • Strengthen transparency in fiscal, monetary, and financial policies, and adopt SDDS.

More specifically, capital account measures that support specific stabilization policies and structural reforms (e.g., developing and integrating interbank money and exchange markets to strengthen monetary management, capital account measures that support current account convertibility, and trade liberalization), and measures that are operationally linked (e.g., borrowing abroad will require allowing time to hold deposits abroad until the proceeds can be effectively used) are introduced first. However, the decision on the scope and sequencing of liberalization of different sectors or subsectors and of the types of capital account transactions that apply to these sectors should be governed by the capacity to manage the risks affecting the specific sectors following the capital account opening. These risks will depend on the hedging instruments available, information systems, internal governance of firms and assets for each sector, the state of development of markets, and the potential for systemic effects and contagion. Given that liberalization in one sector (e.g., corporates) can have effects on other sectors (e.g., government may be indirectly affected by increased credit risks of corporates following external liberalization to the extent that the government guarantees the liabilities of financial institutions that extend credit), a system-wide risk monitoring and risk management approach encompassing all major sectors is necessary to liberalize capital account flows in a safe and sound manner. Table 14.4 illustrates this broadened approach to implementing prudential safeguards—i.e., going beyond prudential supervision and regulation of financial institutions.

The pace of liberalization is also important. The need to build up expertise to manage risk and put in place a critical mass of reforms at each stage of the process will necessarily impose a technical limitation on the speed of reform. It would be much easier to put in place a proper framework for risk management if liberalization was gradual and financial institutions and supervisors had the time to adjust to the new environment rather than being faced with the task of doing so overnight. Authorities would also be able to identify emerging vulnerabilities and address them accordingly through strengthened prudential policies.

However, such a controlled approach may be difficult to sustain. While it may be possible to control the pace of liberalization in its early stages, it will become difficult to deliberately manage the pace of liberalization as domestic markets develop and a greater range of external transactions become liberalized. The ability to circumvent capital controls through nonrestricted channels increases, so that controls lose effectiveness. Moreover, while not fully effective, regulations will create distortionary biases that, at their worst, may actually increase vulnerabilities. There is also a political economy dimension in that controls result in rent-seeking behavior that makes liberalization politically difficult, because liberalization will usually have an impact on profits of specific industries or institutions, and gaining political consensus on which items should be liberalized is not easy.

Moreover, good transparency practices in monetary and financial policies applied to the process of implementing financial sector reforms can greatly facilitate orderly liberalization and effective sequencing of financial sector reforms. Transparency of policies and data becomes particularly critical in the context of market development and capital account opening when transparency practices have to take into account the wider international investor community in addition to the domestic public. Transparency helps foster financial stability during reforms by clarifying institutional design and sequencing strategy, by promoting coordination between monetary and financial policy reforms—policy coordination more generally—and by reducing uncertainty in the midst of structural change.

Concluding Remarks

The international financial community has drawn a number of lessons from the recent financial crises and has taken considerable steps to address them. Crisis countries have suffered tremendously, but these countries are emerging with stronger financial systems. Other countries have also benefited from the lesson and financial systems of the world are likely to become stronger from the experience. Liberalization itself is not the cause of crisis, but rather the weak management of the financial sector and inadequate supervision, together with an inconsistent macroeconomic framework, are usually at the heart of the problem.

Can future crises be prevented? The answer can never be an unqualified yes. Risk taking is an inherent and, indeed, a central aspect of financial activity. It would be impossible to eliminate the risks, and attempts to do so will destroy the function of financial markets. It is therefore important not to be overzealous in our attempts to ensure stability so that we kill the dynamism and risk taking that ensure economic development. Furthermore, in addressing the potential vulnerabilities and risks, it is important that we not just fight the last war. Lessons should be learned from previous mistakes, and we need to make sure that they are not repeated. However, as the environment changes, new and different types of risks and crises will emerge. It is important to sharpen the ability to recognize them and have the capacity to respond to them as they emerge.

Recent efforts to strengthen the “international financial architecture” have indeed focused on reducing potential vulnerabilities and improving the overall resilience of the system, rather than providing specific patches to problems, and such efforts are a many faceted and comprehensive endeavor.45 The IMF is expected to play an important role in the process. Greater transparency in the IMF’s assessment of members’ policies is intended to improve the effectiveness of surveillance and provide the public and financial market participants with more information.46 The development, dissemination, and implementation of internationally recognized standards and codes of good practice could contribute to better informed lending and investment decisions, increased accountability of economic policymakers and private sector decision makers, and improved economic performance. The IMF, in collaboration with the World Bank and other standard-setting bodies, has been active in developing, assessing, and helping to implement various international standards. Initiatives to develop macroprudential indicators of financial sector vulnerability and an early warning system for external crises are under way, as are efforts to develop an operational framework for constructive engagement with the private sector and its involvement in forestalling and resolving crises. Preparation of guidelines on public debt management and sound practices in management of foreign exchange reserves and the ongoing outreach process to disseminate these guidelines are designed to assist countries in adopting good practices through the technical assistance and workshop programs of the Bank and the Fund.

Financial system stability in an integrated global financial market is a complex issue, and identifying and addressing possible systemic vulnerabilities are challenging tasks for individual countries. The IMF and the World Bank’s joint Financial Sector Assessment Program and the associated Financial System Stability Assessment are designed to identify and analyze vulnerabilities, risks, and institutional circumstances in the financial sector, assess observance of relevant financial system standards, provide broader assessments of financial stability and development needs, and formulate near-term and longer-term measures to reduce vulnerabilities and strengthen the financial system. Identification of wider systemic risks and the possible responses to them are being addressed in a variety of international fora. Together these efforts are expected to provide the foundation of a stronger global financial system.

Reference

    AdamsCharlesDonald J.Mathieson and GarrySchinasi1999International Capital Markets: Developments Prospects and Key Policy Issues World Economic and Financial Surveys (Washington: International Monetary Fund).

    AlbaPedroLeonardoHernández and DanielaKlingebiel1999Financial Liberalization and the Capital Account: Thailand, 1988-97,Policy Research Working Paper No. 2188 (Washington: World Bank).

    AlexanderWilliamTomás J.T.Baliño and CharlesEnoch1995The Adoption of Indirect Instruments of Monetary Policy IMF Occasional Paper No. 126 (Washington: International Monetary Fund).

    AriyoshiAkiraKarlHabermeierBernardLaurensİNciÖtker-RobeJorge IvánCanales-Kriljenko and AndreiKirilenko2000Capital Controls: Country Experiences with Their Use and Liberalization IMF Occasional Paper No. 190 (Washington: International Monetary Fund).

    BaliñoTomás J.T. and CharlesEnoch1997Currency Board Arrangements: Issues and Experiences IMF Occasional Paper No. 151 (Washington: International Monetary Fund).

    Bank for International SettlementsAnnual Reports (various issues) (Basel).

    Basel Committee on Banking Supervision1999aCapital Requirements and Bank Behavior: The Impact of the Basle Accord,BCBS Working Paper No. 1 (Basel: Bank for International Settlements).

    Basel Committee on Banking Supervision1999bSupervisory Lessons to Be Drawn from the Asian Crisis,BCBS Working Paper No. 2 (Basel: Bank for International Settlements).

    BisatA.R. BarryJohnston and VasudevanSundararajan1999Sequencing Financial Reform and Liberalization in Five Developing Countries,” in Sequencing Financial Sector Reforms: Country Experiences and Issues,ed. by R. BarryJohnston and VasudevanSundararajan (Washington: International Monetary Fund).

    BlejerMario I. and Silvia B.Sagari1988Sequencing the Liberalization of Financial Markets: Why Developing Countries Ought to Open Up the Domestic Banking Sector Before Freeing Capital Flows,Finance & Development Vol. 25 (March) pp. 1820.

    CalvoGuillermo A.LeonardoLeiderman and Carmen M.Reinhart1996Inflows of Capital to Developing Countries in the 1990s,Journal of Economic Perspectives Vol. 10 (Spring) pp. 12339.

    CrockettAndrew1997aGlobal Capital Markets and the Stability of Banking and Financial Systems,” in Banking Soundness and Monetary Policy: Issues and Experiences in the Global Economy papers presented at the Seventh Seminar on Central Bankinged. by CharlesEnoch and John H.Green (Washington: International Monetary Fund).

    CrockettAndrew1997bThe Theory and Practice of Financial Stability,Essays in International Finance No. 203 (Princeton, New Jersey: Princeton University).

    CrockettAndrew1997cWhy Is Financial Stability a Goal of Public Policy?” in Maintaining Financial Stability in a Global Economy: A Symposium sponsored by the Federal Reserve Bank of Kansas CityJacksonHoleWyomingAugust2830.

    DailamiMansoor1999Managing Risks of Capital Mobility,World Bank Policy Research Working Paper No. 2199 (Washington: World Bank).

    EichengreenBarry and PaulMas son with HughBredenkampBarryJohnstonJavierHamannEstebanJadresic and İNciÖtker1998Exit Strategies: Policy Options for Countries Seeking Greater Exchange Rate Flexibility IMF Occasional Paper No. 168 (Washington: International Monetary Fund).

    EichengreenBarry and MichaelMussa with GiovanniDell’Ariccia and others1998Capital Account Liberalization: Theoretical and Practical Aspects IMF Occasional Paper No. 172 (Washington: International Monetary Fund).

    ErricoLuca and AlbertoMusalem1999Offshore Banking: An Analysis of Micro and Macro-Prudential Issues,IMF Working Paper 99/5 (Washington: International Monetary Fund).

    Financial Stability Forum2000aReport of the Working Group on Capital Flows” (Washington). Available via the Internet: http://www.fsforum.org.

    Financial Stability Forum2000bReport of the Working Group on Highly Leveraged Institutions” (Washington).

    Financial Stability Forum2000cReport of the Working Group on Offshore Financial Centres” (Washington). Available via the Internet: http://www.fsforum.org.

    FischerStanley1997Capital Account Liberalization and the Role of the IMF,IMF SurveyOctober20 pp. 32124.

    FischerStanley1999Frequency of Global Crises Highlights Need to Consider International Lender of Last Resort,IMF SurveyJanuary11 pp. 68.

    Folkerts-LandauDavid and Carl-JohanLindgren1998Toward a Framework for Financial Stability,World Economic and Financial Surveys (Washington: International Monetary Fund).

    FrankelJeffrey1999Exchange Rate Regimes and Financial Integration,Brookings Policy Brief No. 51on theInternational Financial Architecture (June).

    GarberP. and M.Taylor1995Panel in the Wheel of Foreign Exchange Markets: A Skeptical Note,Economic Journal Vol. 105 (January) pp. 17380.

    International Monetary Fund1998Financial Crises: Characteristics and Indicators of Vulnerability,Chapter IV in World Economic Outlook World Economic Surveys (Washington: IMFMay) pp. 7497.

    International Monetary Fund1999aInvolving the Private Sector in Forestalling and Resolving Financial Crises (Washington).

    International Monetary Fund1999bSummary of International Monetary Fund Economic Forum, “Getting It Right: Sequencing Financial Sector Reforms,IMF SurveyAugust2 p. 241.

    International Monetary Fund1999cMacroprudential Indicators and Data Dissemination—Background Paper,SM/99/295 Supp. 1December15.

    International Monetary Fund2000aReport of the Managing Director, International Monetary and Financial Committee on Progress in Reforming the IMF and Strengthening the Architecture of the International Financial System (Washington).

    International Monetary Fund2000bExperience with Basel Core Principle Assessments.Available via the Internet: http://www.imf.org/external/np/mae/bcore/exp.htm

    JohnstonR. Barry1994The Speed of Financial Sector Reform: Risks and Strategies,IMF Paper on Policy Analysis and Assessment 94/26 (Washington: International Monetary Fund).

    JohnstonR. Barry1998Sequencing Capital Account Liberalizations and Financial Sector Reform,IMF Paper on Policy Analysis and Assessment 98/8 (Washington: International Monetary Fund).

    JohnstonR. BarrySalimDarbar and ClaudiaEcheverria1999Sequencing Capital Account Liberalization: Lessons from Chile, Indonesia, Korea, and Thailand,” in Sequencing Financial Sector Reforms: Country Experiences and Issuesed. by R. BarryJohnston and VasudevanSundararajan (Washington: International Monetary Fund).

    JohnstonR. Barry and İNciÖtker-Robe1999A Modernized Approach to Managing the Risks in Cross-Border Capital Movements,Policy Discussion Paper 99/6 (Washington: International Monetary Fund).

    JohnstonR. Barry and VasudevanSundararajan1999Managing Financial Sector Liberalization: An Overview,” in Sequencing Financial Sector Reforms: Country Experiences and Issuesed. by R. BarryJohnston and VasudevanSundararajan(Washington: International Monetary Fund).

    KaminskyGraciela and CarmenReinhart1999The Twin Crises: The Causes of Banking and Balance of Payments Problems,American Economic Review Vol. 89 (June) pp. 473500.

    LaneTimothy1999The Asian Financial Crisis: What Have We Learned?Finance Development Vol. 36 (September) pp. 4447.

    LaneTimothy and others1999IMF-Supported Programs in Indonesia Korea and Thailand IMF Occasional Paper No. 178 (Washington: International Monetary Fund).

    LindgrenCarl-JohanGillianGarcia and MatthewSaal1996Bank Soundness and Macroeconomic Policy (Washington: International Monetary Fund).

    LindgrenCarl-Johan and others1999Financial Sector Crisis and Restructuring: Lessons from Asia IMF Occasional Paper No. 188 (Washington: International Monetary Fund).

    López-MejíaAlejandro1999Large Capital Flows: A Survey of the Causes, Consequences, and Policy Responses,IMF Working Paper 99/17 (Washington: International Monetary Fund).

    MaeharaYasuhiro1998Financial Stability in Southeast Asia,Journal of Asian Economics Vol. 9 (Summer) pp. 22735.

    McKinnonRonald I.1993The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy (Baltimore: Johns Hopkins University Press2nd ed.).

    McKinnonRonald I. and HuwPill1998International Over-Borrowing: A Decomposition of Credit and Currency Risks,World Development Vol. 26 No. 7 pp. 126782.

    New York Foreign Exchange Committee1994Reducing Foreign Exchange Settlement Risk (New York).

    ObstfeldMaurice1996Models of Currency Crises with Self-Fulfilling Features,European Economic Review Vol. 40 (April) pp. 103747.

    ObstfeldMaurice and KennethRogoff1995The Mirage of Fixed Exchange Rates,Journal of Economic Perspectives Vol. 9 (Fall) pp. 7396.

    SundararajanVasudevan1999Prudential Supervision, Bank Restructuring, and Financial Sector Reform,” in Sequencing Financial Sector Reforms: Country Experiences and Issuesed. by R. BarryJohnston and VasudevanSundararajan (Washington: International Monetary Fund).

    WhiteWilliam R.2000What Have We Learned from Recent Financial Crises and Policy Responses?BIS Working Paper No. 84 (Basel: Bank for International Settlements).

    WilliamsonJohn and MollyMahar1998A Survey of Financial Liberalization Essays in International Finance No. 211 (Princeton, New Jersey: Princeton University, Department of Economics, International Finance Section).

What constitutes “key institutions” and “key markets” is important in defining financial system stability. Generally, banks are viewed as the key institutions in that instability in the banking system has a greater capacity to generate systemic contagion than difficulties elsewhere in the financial sector (via greater susceptibility to runs and the operation of the payments system), though the distinctions have become increasingly blurred with the problems at key nonbank institutions also having growing potential for significant spillover effects. Similarly, financial and other asset markets are considered to be the focus of concern rather than markets for goods and services in having the capacity to cause wider economic damage through their greater potential impact on macroeconomic variables (see Crockett, 1997c).

There are a number of issues that deserve further attention, which the present paper could not address due to space limitations. See comments by L.M. Cheong and F. Morandé in this chapter for a number of suggestions.

Further indications of the magnitude of the changes that took place include these: the volume of international lending in new medium- and long-term bonds and bank loans reached an estimated value of $1.2 trillion in 1997, compared with $0.5 trillion in 1988; cross-border transactions in bonds and equities in Organization for Economic Cooperation and Development (OECD) countries reached more than 100 percent of GDP in 1995, compared with only 10 percent in 1980; the average daily turnover in foreign exchange markets reached $1.6 trillion, up from $0.20 trillion in 1986; the ratio of total global market capitalization of stock markets relative to world GDP rose from 23:1 in 1986 to 68:1 in 1996; and derivatives markets expanded from $7.9 trillion in 1991 to $40.9 trillion in 1997 (see Bank for International Settlements annual reports).

An example of such risk that has received increased attention in recent years is foreign exchange settlement risk, which arises because the settlement of the two legs of a foreign exchange transaction typically takes place through different payment systems in different geographical areas and time zones.

When appropriate market structures, institutions, and confidence in the system are lacking, it is also possible for market participants to keep their money out of the financial system (e.g., under the mattress, though monetary authorities have some ability to offset the effect by supplying more currency).

With an open capital account, the role of international lender of last resort assumes importance. See Fischer (1999) on this topic.

A combination of a liberalized financial market and an effective restriction on capital flows is unlikely to be achievable, as developed financial markets provide avenues of circumvention of flows. See the fifth point below.

Recycling of revenues of oil-exporting countries is one example.

It should be noted, however, that sometimes markets may not assess risks appropriately, and the resulting unwarranted optimism on the part of the investors may create potential vulnerabilities for the financial system through macroeconomic stability risks (see below, as well as comments by L.M. Cheong in this chapter).

See, for example, Errico and Musalem (1999).

It should be noted, however, that while in a majority of financial crisis cases the capital account was open, there were also crisis countries where it was closed, and in some of the countries with open capital accounts, the financial crises had nothing to do with capital account liberalization (e.g., the savings and loan crisis of 1980 in the United States).

Such inflows could occur following an opening up of the capital account or a reappraisal of economic prospects of a recipient country, or may reflect conditions in creditor countries such as low returns.

López-Mejia (1999) provides evidence that in 15 of the 18 heavy capital inflow episodes analyzed in his paper, the ratio of bank lending to the private sector as a share of GDP was higher in the inflow periods than in the years prior to the inflows.

Standard open economy models anticipate that equity and real estate prices are likely to increase following capital inflows if other assets are included in the analysis (see Calvo, Leiderman, and Reinhart, 1996; and López-Mejia, 1999). Adding to the vulnerability of the financial system is banks’ inability to cover their losses with the reduced value of collateral—consisting mainly of previously inflated equity and real estate—and the rise in interest rates accompanying asset price declines that cause agents to default on their loans (the experiences of the Asian crisis countries are a case in point).

As is well known, increased capital mobility does reduce the scope for pursuing independent exchange rate and monetary policy objectives, and the scope for policy autonomy is correspondingly constrained.

Recent years have experienced many examples of such capital flow reversals, in many cases with the instability in currency markets followed by severe problems in the financial sector. Based on a number of empirical studies that identified currency and banking crises for a group of more than 50 countries for the period 1975-97 (see IMF, 1998), banking and currency crises have become more contemporaneous since the late 1980s, 10 out of 12 instances of banking crises occurring in the same year. In 7 of these 12 cases, currency crises preceded banking crises by one year and in 4 instances by two years. While cases of reverse order were not found in the study, the study excludes the most recent Asian crises of 1997-99, in which currency and banking crises did indeed feed each other.

See, for example, Obstfeld (1996).

This asymmetry in the size of transactions by large institutions relative to the small and medium-sized markets and its likely impact on market practice and market integrity has been a source of concern. See the Report of the Financial Stability Forum (FSF) Working Group on Highly Leveraged Institutions (HLIs), FSF (2000b), for an analysis.

FSF (2000a) provides an analysis and recommendation from a risk management perspective, including sources of bias in national policies that may encourage short-term flows.

In Korea, for example, the crisis in the banking and corporate sectors and the related payments crisis were to a large extent rooted in excessive onlending of foreign currency to corporate borrowers with inadequate foreign earnings. The exposures were not adequately monitored and controlled either by the banks or by the supervisory authorities. Similarly in Thailand, banks and finance companies had huge foreign exchange exposures through borrowing offshore to finance their aggressive domestic credit expansion. Although the Indonesian authorities had imposed limits on banks’ open foreign currency positions, these were either poorly enforced or circumvented through the expedient of offshore affiliates outside the control of the regulators (see Ariyoshi and others, 2000; and McKinnon and Pill, 1998).

The so-called Herstatt risk refers to the risk of settlement failure arising from a settlement of different currencies traded in the foreign exchange market with settlement occurring in different time zones. Other types of settlement risks in the foreign exchange market are discussed in New York Foreign Exchange Committee (1994).

The potential systemic effects of buildup of leverage and collapse of large highly leveraged institutions is analyzed in FSF (2000b).

Among the institutional framework issues, of most concern are those related to market integrity arising from secrecy, trust, and asset regimes found in certain OFCs, which could encourage money laundering and other illicit financial activities. A recent study by the FSF Working Group on OFCs (FSF, 2000c) has concluded that while OFCs to date do not appear to have been a major causal factor in the creation of systemic financial problems, they have featured in some crises, and it notes that future problems in OFCs could have consequences for other financial center.

For example, the de facto U.S. dollar peg in Thailand and the Philippines, the horizontal exchange rate band regime in Korea, and the crawling band arrangement in Indonesia.

The observation that intermediate regimes such as adjustable pegs may not be viable under highly developed global capital markets has gained popularity especially after the Asian crisis. See, for example, Obstfeld and Rogoff (1995), Frankel (1999), and Johnston and Ötker-Robe (1999). A country may not be able to signal full commitment to a completely flexible exchange rate and thus eliminate the sustainability issue, to the extent that it may not be seen to be willing to accept very large changes in the exchange rate.

In some cases (e.g., Chile, Israel, Poland, Singapore), exchange rate arrangements have evolved in a progressive manner (involving a switch from fixed exchange rate regimes to successively widening horizontal bands or crawling bands or to managed or free floats), with the degree of flexibility depending on the size of the capital inflow problem (see Johnston, 1998, and Johnston and Echeverria, 1999). See also Mussa and others, 2000 for an analysis of the choice of exchange regimes in different groups of countries.

By further reducing currency and transfer risk, a CBA may also reduce the country risk premium and thus discourage some of the high-risk, high-return investors that tend to be more footloose.

The recent experiences of the Asian countries have highlighted how financial vulnerabilities could increase in the absence (or lack of enforcement) of adequate prudential regulations. These shortcomings enabled banks to channel large capital inflows to risky projects, exposing them to credit and foreign exchange risks and maturity mismatches in foreign currencies.

Financial systems in European countries exhibited strong resilience in the face of the Exchange Rate Mechanism (ERM) crisis of 1993 that involved large capital flows and exchange rate movements. In the Asian crisis of 1997-98, economies such as Singapore and Hong Kong SAR, and Argentina, Chile, and Peru, which have stronger prudential frameworks, have fared well, though having stronger macroeconomic and external conditions than in the crisis-hit countries certainly contributed to the relative stability.

See FSF (2000a) for an emphasis on national balance sheets and sectoral risk management, including the importance of good practices in sovereign debt management. For the usefulness of appropriate aggregate indicators of vulnerabilities in key sectors, see IMF (1999c).

Of course, this could happen in a domestic context when development of markets is rapid, or when institutions are allowed into new lines of business. Also, once in a while, euphoria may drive risk taking to excessive heights even for well-established risks like credit risk, ending in a painful collapse.

The famous examples include the Barings Bank and Daiwa Bank incidents, in which the risks involved were fairly straightforward.

The IMF and the World Bank, with expert assistance from a number of cooperating central banks and national supervisory institutions, have been conducting assessments of member countries’ compliance with relevant financial system standards, as input into broader assessments of stability and development needs under the FSAP. The standards covered include BCP and, as appropriate, the International Organization of Securities Commissions (IOSCO), Principles of Securities Regulation, International Association of Insurance Supervisors (IAIS), Insurance Supervision Principles, Core Principles of Systemically Important Payment Systems, and Monetary and Financial Policy Transparency. Results from 26 BCP assessments conducted so far (though including only one industrialized country) indicate that serious weaknesses exist in banking supervision in many countries, especially in risk management, the taking of corrective actions, and consolidated supervision (see IMF, 2000b). Implementation and enforcement of rules and regulations were often found to be weak, and deficits were found in many of the necessary preconditions for effective supervision, such as accounting systems, loan valuations procedures, legal processes, and market discipline. Lessons of experience with assessments of other standards are under preparation.

The Group of Ten has established a working party on financial sector consolidation, to understand the trends, causes, and policy implications of consolidation in the financial industry.

In recession, loan losses at banks may reduce their capital and thus constrain lending, resulting in a credit crunch. Basel Committee (1999a) provides a survey of the literature on the effects of capital requirement on the macroeconomy.

Basel Committee (1999b) analyzes this possibility. Although it does not find conclusive evidence either way on regulatory distortions, it recognizes that current risk weightings do not adequately reflect risk, and found some support for the possibility of maturity of lending being affected. The Basel Committee is currently in the process of reviewing the system for assigning risk weighting.

See, for example, Fischer, 1999).

Many of the issues are debated under the general title of “International Financial Architecture.” Numerous papers have been written on the topic. IMF (2000a) provides an overview of the progress to improve the architecture.

The authors thank L.M. Cheong for bringing this point to their attention.

This can take the form of an explicit tax, as in Brazil, or be constructed as an unremunerated reserve requirement, as in Chile.

There is some debate as to whether there was circumvention through trade credits that were not subject to the measures, and discussion that the effectiveness may not be as certain as national statistics indicate.

For a description of the stages of financial liberalization, see Alexander and others (1995) and Sundararajan (1999).

For the ongoing efforts to improve the architecture, see IMF (2000a).

Several initiatives to improve transparency of IMF’s operations and policy advice include encouragement of the release of public information notices following Article IV consultations; a pilot program for the voluntary release of Article IV staff reports; and establishment of presumption to release Letters of Intent and Memorandum of Economic and Financial Policies of Fund-supported programs.

    Other Resources Citing This Publication