Current Challenges in
Financial Regulation for
Emerging Markets
Keynote speech at the
2nd EMG Conference
“Emerging Markets Finance”
May 15-16, 2008 , London
By Stijn Claessens
Professor of International Finance Policy, University of Amsterdam
Assistant Director, Research Department,
Financial Studies Division, International Monetary Fund
Structure of Speech
1. Importance of financial sector development
2. Drivers of financial sector development
3. Current challenges in finance regulation
4. Issues facing emerging markets
5. Conclusions
1. Importance of financial sector
development
• Finance operates through multiple channels
–
–
–
–
–
–
Pooling resources, subdividing shares
Transferring resources across time and space
Managing risk
Generating and providing information
Dealing with incentive problems
Resolving competing claims on wealth generated
• Empirically, finance shown to matter for
– Growth, Volatility, Poverty, Inequality, etc.
– Entry channel especially important in emerging markets
Private Credit and GDP per capita growth
Finance and Volatility
e(Growth in Headcount | X)
Finance and Poverty
e(Private Credit | X)
Residuals
Fitted Values
e(Growth in Gini Coefficient | X)
Finance and Inequality
e(Private Credit | X)
Residuals
Fitted Values
2. Drivers of financial sector
development: knowledge to date
Financial development depends on:
A. Macro-economic and fiscal stability
B. Real sector
C. Legal and judicial system
D. Proper regulation and supervision
E. Access to credible information
F. Competitive & contestable markets
A. Macro-economic, fiscal stability
• Stable macro-economic environment
– Moderate, positive real interest rates
– Appropriate exchange rate regime
• Stable fiscal environment
– Low fiscal deficits to avoid crowding out
– Limited direct role of the government in financial
intermediation
– Low financial sector taxation
Private Credit and Inflation
B. Real sector
• Finance input for real sector and vice-versa
– Vicious and virtuous relationships
– Development and effectiveness of financial and
real sector depend on many similar factors
• Yet still separate finance reform agenda
– Additional positive effect of finance on growth
– Financial sector represent allocation of control
rights, link to general political economy of reform
C. Legal and judicial system
•
Good property rights, laws
– Effective legal system very important for financial
markets, financial intermediation
– How equity and creditor rights affect financial
development, external financing, dividend patterns,
growth, firm valuation, etc. is well documented
– Includes a well-functioning judicial system that
enforce these rights
Private Credit and Creditor Rights
Stock Market and Shareholder rights
Private Credit and Contract
Enforcement
D. Regulation and supervision
•
Regulation and supervision of intermediaries,
markets
– Financial sector is highly regulation dependent
– Regulation differs from supervision. Regulation
needs to balance market discipline and
government supervision
– Without checks and balances, too much power in
the hand of supervisors/regulators retards financial
development and creates risks
What Works Best for Banks?
Rethinking Bank Regulation: Till Angels Govern, James Barth,
Gerard Caprio and Ross Levine, Cambridge University Press, 2006
• Given typical institutional and political environment…
– Avoid relying only on official oversight, restrictions etc.
– Emphasize private monitoring / incentives
– Stress Basel II’s third pillar (not capital / official oversight)
– Increases in deposit insurance generosity increase moral
hazard and thereby increase fragility
• Supervisors have crucial role
– Support market discipline, not supplant it
– Foster / force information disclosure
E. Access to credible information
• Information is essential for risk management,
access to finance, efficiency of intermediation
– Information to be available on borrowers,
consumers and financial intermediaries
– Quality of accounting & auditing, rating agencies,
credit bureaus, key components of informational
infrastructure
– Information infrastructure has to be contestable
Better creditor information sharing
increases private credit and eases
external financing
F. Competitive & contestable markets
• Contestability of financial system key
– Contestability matters more than market structure
– State-owned institutions hinder
– Entry (including foreign institutions) helps stability,
efficiency, access
– Structure (bank versus markets) matters less than
having right fundamentals and open systems
• Banks complement securities markets--in
financing, corporate governance--and vice-versa
• Most financing depends on similar determinants
• Balanced development can, however, provide a
spare wheel
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Competitiveness depends more on
contestability than market structure
H-Statistic (Pooled OLS)
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Lower private credit with higher share of
government-owned banks
Firms are less likely to rate high interest
rates and access to long-term loans as
major obstacles with more foreign banks
Access to Long Term Loans as an Obstacle
High Interest Rate as an Obstacle
60
80
70
50
60
40
50
20th %ile
20th %ile
40
50th %ile
30
50th %ile
80th %ile
80th %ile
30
20
20
10
10
0
0
Small
Medium
Large
Small
Medium
Large
Yet countries vary greatly in openness
(WTO Commitments Index Value)
Index - lower values indicate more openness
70.0
59
60.0
50.0
42
40.0
34
32 30 30
30.0
20 20 20
20.0
15 15
10 10 10 10
10.0
5
n/a n/a
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Stock markets and banks complement
each other in growth and development
High banking
development
4
3
Per capita growth,
1976-93
2
Low banking
development
1
0
Illiquid
Liquid
Initial stock market liquidity
Source: Demirgüç-Kunt and Levine, 1996.
3.
Current challenges in finance
A. Triggers and changes
B. Overall approach
C. Changing special nature of banks
D. Competition policy
E. Consumer protection
F. Costs of regulation
G. Harmonization
A. Triggers and changes
• Financial services are changing rapidly
– Deregulation: within markets and products, across
markets, geographic, including cross-border
– Technology: advances in information, particularly
internet and increased remote delivery
• Factors are changing financial services industries
structures and altering forms of provision
– Banks and finance becoming less special; increasingly
more substitutes available; more remote delivery
possible; local markets less relevant; lines between
products and financial institutions blurring
– Globalization accelerating: increased (gross) capital
flows, cross-border financial services, foreign bank
entry, listing in financial centers
Changing real world has implications
also for financial intermediation
• Nature of the firm altering
– Intangibles, new economy, network-type assets
more important for production and productivity
• Investments to be financed changing
– Investors invest in “ideas”, rather than fixed assets
– Ideas need more protection for investors
– Yet often not suited for organized/formal markets
• Implications for financial sector
–
–
–
–
Fewer fixed assets: makes debt more difficult
Higher risk: requires other financing structures
Greater importance of corporate governance
More VC-type, more equity markets for VC to exit
B. Overall approach
• Overall approach: reaffirming fundamentals
– New evidence confirms crucial role of fundamentals
– Yet need to revisit continuously fundamentals
• Greater emphasis on enabling environment
– Property rights, information infrastructure, etc.
• Reduced, but more focused role of government
– Do not expect government to solve all problems
– But neither will market always
– Focus on core role of government, with some
market-friendly interventions
C.
Special nature of banks
• Greater substitutes for bank liquidity available
– Reducing specialness of banks
• New roles for banks and increased conglomerates
– More risk managers, as within financial conglomerates
– Introducing new risks and oversight challenges, e.g., LCFI
• Revisit prudential and institutional-oriented approaches
– Revisit tools/approaches used for managing risks  Basel II
– Higher transparency, better corporate governance  Pillar III 
– Protect more core elements (payments system) against spillovers
– Less cylinder approaches, stress more common elements
– Reduced special nature of banks implies less need for public
safety net and requires adjustment of standards
D. Competition policy
• Competition is important in the financial sector
– As in other sectors, competition affects efficiency, costs and
incentives of institutions & markets to innovate
• Competition in finance, however, is complex, w/tradeoffs
– Access to credit depends on franchise value, but degree of
competition can negatively/positively affect access
– Too much competition can undermine stability → crises
– Structure matters, but in complex ways, e.g., effects of
entry/exit rules, economies of scale/scope, networks, etc.
– Financial services industries are continuously changing
Competitive landscape is changing
More and better competition policy
both possible and needed
• Finance and banks particularly less special
• Global and across types of services/institutions
• The (new) competition policy paradigm to
involve Three Pillars
1. Better approach to competition policy
2. Better institutional arrangements
3. Better (new) tools to be used
• Ultimate goal: (new?) paradigm
– Competition policy to be functional, global
– To resemble other network industries (e.g.,
telecommunications, energy)
Approaches
• Competition policy to combine three approaches
– Institutional: assure contestable markets by “proper”
entry/exit of institutions, domestic and cross-border
– Functional: assure contestable markets by leveling
playing field (in all dimensions) across similar financial
products & services
– Production: assure efficiently provided, equal
accessible, affordable network services (information,
distribution, settlement, clearing, payment, etc.)
• So far: Institutional: Big barriers have been removed,
but many small remain. Functional: long way to go
Production: less discussed so far
More gains to be gotten from
institutional and functional approach
• Further liberalize/harmonize across markets, sectors,
products, by functions so locations/labels not matter
• Complex, since:
– Costs of regulation hard to assign to specific functions,
products, e.g., payments services
– Path dependency, e.g., tax differences in savings products
– Subtle distortions/benefits, e.g., safety net, LoLR
• Policy responses
– More integrated/single supervisors may or may not help
– Global standards can help, but still country differentiation
– Competition—between markets, sectors, products and
regulators—key to force more effective harmonization
Institutional arrangements
• Competition policy to be given more weight
– Competition policy to be (more) separate from supervision
– Effective competition authority with good enforcement
• Competition policy to be more harmonized
– Horizontal and vertical across various financial services
– For specific inputs/links, including other, non-financial
• Competition policy to be more coordinated
– Integrate with overall information/technology competition policy
– Many markets are global, but competition policy not yet
– Existing mechanisms can be used more: WTO (all GATS
modes), FTAs
Tools to analyze competitiveness
• Analysis is, and will remain, difficult
– Market and product definitions: will become even harder
– Barriers to entry complex: may arise from sunk costs,
economies of scale and scope, externalities
– Network effects exist in supply, demand, and distribution
• Tools far behind and need to be adjusted
– Borrow more from traditional IO or other (services), but adapt
to “special nature” of financial services
– Less market structure, more conduct analysis
– More focus on access pricing and policies for key market
infrastructures (e.g., payments systems, information, credit
bureaus, trading systems)
E.
Consumer protection
• Assuring proper business conduct
– Long-standing issue, but recent events show that small “distortions”
hurt consumers and negatively affect integrity
– Limit conflict of interests, increase oversight, especially in capital
markets, of key issues (e.g., A&A), take strong actions (e.g., NY SEC)
• Protecting individual consumers
– Can no longer assure “fairness” of products and markets
– “Buyer beware” to be matched by increased “truth in advertising”
requirements, liability and means of users to take legal actions
• Assuring consumers obtain the greatest benefits
– Increased choices and complexity not (yet) matched by knowledge
– Requires more financial education, starting at an early age
F.
Costs of regulation
• Deregulation followed by reregulation: now too much
regulation and too intense oversight?
– Direct and indirect (compliance) costs have increased
– With possible adverse effects, e.g.,
• SOX may lead to migration of US IPOs to UK; fewer new listed firms
• AML/CFT can affect access of households
– Markets players and governments have recognized this
• e.g., EU Action Plan streamline regulations, US competitiveness reports
• Proper policy responses
– More formal cost-benefit analysis needed
– More transparency and greater consultation to balance tradeoffs
• Without inviting capture, need to have broad(-er) representation of
producers and consumers in processes
G. Harmonization
• Big barriers have been removed, but many small remain
• Further harmonize across markets, sectors and products,
by functions, so that labels no longer matter. Complex as:
– Costs of regulation hard to assign to specific functions/products
– Path dependency, e.g., tax differences
– Subtle distortions/benefits, e.g., safety net, LLR
• Policy responses:
– More consolidated/single supervisory authorities may help
– Standards help globally, but country differentiation unavoidable
– Better data and more transparency on prices and costs
– Competition—between markets, sectors, products and regulators—
key to force more effective harmonization
U.S. Regulatory Regime: Multiple, Overlapping,
Inconsistent and Costly Regulation
Justice Department
Umbrella or
Consolidated
Regulator
Primary/
Secondary
Functional
Regulator
• Assesses effects of mergers
and acquisitions on
competition
Federal Courts
Financial Holding Company
• Fed
• OTS
• SEC
• Ultimate decider of banking,
securities, and insurance
products
“Dual Banking”
National
Bank
• OCC
• FDIC
Federal
Branch
State Bank
• State Bank
Regulators
• FDIC and/or
• Fed
Federal
Savings
Bank
• OTS
• FDIC
Foreign
Branch
Limited
Foreign
Branch
• Fed
• Host County
Regulator
• OTS
• Host County
Regulator
Insurance
Company
• 50 State Insurance
Regulators plus
District of Columbia
and Puerto Rico
Securities
Broker/Deale
r
• FINRA
Other
Financial
•Companies
Fed
• SEC
• CFTC
• State Securities
Regulators
• State Licensing
(if needed)
• U.S. Treasury for
some products
Key
CFTC – Commodity Futures Trading Commission
FDIC – Federal Deposit Insurance Corporation
Fed – Federal Reserve
• OCC
• Host County
Regulator
FINRA - Financial Industry Regulatory Authority
OCC – Comptroller of the Currency
OTS – Office of Thrift Supervision
SEC – Securities and Exchange Commission
4. Issues facing emerging markets
A. International financial integration
a) Stability and volatility
b) Cross-border activities
c) Access concerns
B. Development strategies
a) Application of international standards
b) Adaptation of international standards
C. Corporate governance
D. Political economy
A. International financial integration
a)
stability and volatility
• Developing countries, emerging markets especially, subject
to rapid financial integration
– Large capital flows, foreign bank entry, capital market migration
• Forcing adjustment faster than in current developed’ past
– Need for more rapid institutional development
– Intermediate level of (financial) development/openness most risky
• Integration → more stability, but at times also volatility 
– Greater emphasis on measurement and management of risks
– May need to keep toolkit to intervene (e.g., capital account controls,
circuit brakers, tighter restrictions)
The many links between capital flows
and domestic cycles
Economic Reform and Financial Liberalization
Capital Inflows
Macroeconomic
conditions and policy
response
Investment boom
Banking sector:
initial conditions and
regulatory framework
Asset price increases
Consumption boom
Increase in short-term
debt and foreign
exchange exposure
Credit Channel
Macroeconomic vulnerability
increases while banks portfolios
become riskier
Collateral
Lending boom
b)
Cross-border activities
• Increased foreign bank presence, foreign capital markets
activities on- and offshore, raising specific questions
– Costs of regulation and supervision increase with (multiple)
coordination with home countries
– Yet capacity of emerging markets lower and effects of banking
failure and financial crisis higher
– Foreign investors/financial institutions not internalize all issues
• Lack of paradigm more costly for emerging markets
– Rule for cross-border bank resolution, capital markets oversight
ambiguous in some respects
– Inefficient responses, e.g. subsidiaries, create additional costs/risks
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Foreign Ownership of Banks Varies Greatly
Percent
90
80
80
70
60
30
20
10
56
54
50
40
40
30
26
20
16
15
11
9
8
7
7
7
6
2
n/a n/a
0
c) Access concerns
Starting point: Access vs. Use
Users of formal
financial services
Population
No need
Voluntary selfexclusion
Cultural/religious reasons
not to use/indirect access
Non-users of
formal financial
services
Insufficient income/high risk
Involuntary
exclusion
Discrimination
Contractual/Informational
framework
Access to financial services
No access to financial services
Price/Product features
Use of finance around the world
varies greatly
Financial use relates to financial
depth, but is not the same
United States
2.0
1.8
1.6
Switzerland
1.4
Private Credit / GDP
.
1.2
1.0
0.8
0.6
0.4
Estonia
Colombia
0.2
Lithuania
0.0
0
20
40
60
% of Households Using Financial Services
80
100
- 0 .1
- 0 .1 2
A c c e s s to l o n g te r m
lo a n s
i n fo r m a ti o n o n c u s to m e r s
In a d e q u a te c r e d i t/fi n a n c i a l
le a s in g e q u ip m e n t
A c c e s s to fi n a n c i n g fo r
A c c e s s to e x p o r t fi n a n c e
A c c e s s to n o n - b a n k e q u i ty
A c c e s s to fo r e i g n b a n k s
B a n k s l a c k m o n e y to l e n d
w i th b a n k s
N e e d s p e c i a l c o n n e c ti o n s
H i g h i n te r e s t R a te s
B a n k p a p e rw o rk / b u re a u c ra c y
C o l l a te r a l r e q u i r e m e n ts
F i n a n c i n g o b s ta c l e
SMEs complain the most
0 .0 4
0 .0 2
0
- 0 .0 2
- 0 .0 4
- 0 .0 6
- 0 .0 8
L a rg e
S m a ll
Most access barriers vary as expected with
country characteristics
Access BarriersDeposits
Access BarriersLoans
Banking Freedoms
- 0.563***
-0.474***
Media freedom
- 0.327**
-0.425***
Credit information index
-0.302**
-0.275**
Official supervisory power
0.231**
0.071
Market-based supervision
-0.1
-0.374**
0.264*
0.209
Government bank share
-0.002**
0.004***
Foreign bank share
-0.005**
-0.001
-0.06
0.03
Physical infrastructure failures
Creditor rights
Access concerns
• Large foreign bank entry  more access generally, but:
– Access to information-intensive firms may suffer when hardinformation banks come in
– Local information production: when foreign banks list abroad, less
information, less market discipline, more complex monetary policy
• Large migration in capital markets  benefits but:
– While larger firms gain, local liquidity can decline, making it harder
for other (small) firms to raise financing locally
– Local capital markets activities in general decline as business is
reduced, hindering development
• Policy responses
– Specific corporate governance and listing requirements for local
subsidiaries?
– More harmonization and more specialization in capital markets?
B. Development strategies
• Countries have less freedom to pursue own approaches
– Good on one hand, since state has mostly not been productive
– Yet many now successful economies have had some interventions
•
Countries can combine, but only to some extent
– Can benefit from committing through international agreements
– While pursuing some national objectives, through lending
requirements, development financial institutions, etc.
– Balance can be precarious: deter entry, raise costs, distort
a.
Application of international
standards
• Standards (Core 25, Basle II, IOSCO, etc) help, but:
• Many not applicable, too sophisticated and sometimes even
wrong given issues facing developing countries
– Markets missing, capacity to implement lacking, enforcement, etc
– Special nature of banks and safety net: can be perverse
• Many country-specific requirements and tradeoffs
– E.g., degree of competition and access to financing relate differently
when information more obscure. Size of market matters
• Yet signal of poor compliance a problem. Implications:
– Regulations to be applied to vary. Focus on key, priority elements:
regulatory governance, corporate governance, transparency
– Consider multiple enforcement approaches, not just public
b.
Adaptation of international
standards
• Adapt standards and assessment over time
– Standards to be adapted to changing world and lessons learned
– Need to consider assessor/methodologies consistencies
• Need to include all relevant parties in review
– Increase stake of emerging markets in international standard setting
forums (BCBS, CPSS, etc.) and IFIs (IMF, WB)
– Consider legitimacy, which may mean raising stakes even more
– Provide technical assistance in negotiations in FTAs, GATS, etc to
level playing field
– Balance private sector/producers’ interests with consumers’
c. Specific competition (policy) issues for
emerging markets
• Competition policy especially complex
– Often small systems. Many links between finance, corporate sector,
government, political economy. Limited data to measure
– Hard to develop a credible competition agency. Compromise, e.g., inside
instead of outside supervisory agency, can be costly
• Commitment to pro-competition more beneficial
– Since competition policy authorities weaker, political economy more
adverse and credibility at a premium, external can help
– International agreements (WTO, FTAs) can commit/enforce
– Active role of government can be needed given externalities and
coordination issues, e.g., payments system
C. Corporate and regulatory governance
• Deeper challenges for development
• Corporate governance can be elusive
– Better protection of investors
– Better governance inside firms
– Better incentives to accumulate human capital
• Regulatory governance and enforcement
– Crucial to development.
– North (1991): “single most important determinant of
economic performance”
– Financial markets depend on legal environment, but
incomplete without enforcement
Median Voting Premium
Weak corporate governance translates into
higher cost of capital
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
1
2
3
4
Equity Rights
Excludes Brazil
5
6
Return on Assets
Better corporate governance translates into
somewhat higher returns on assets
8
7
6
5
4
3
2
1
0
1
2
3
4
Equity Rights
Excludes Mexico and Venezuela
5
6
Return on Investment relative to
Costs of Capital
But much better higher returns on investment
relative to cost of capital
1.1
1
0.9
1
2
3
4
0.8
0.7
0.6
0.5
Equity Rights
5
6
Enforcement dominates laws-on-the-books
y = 0.9366x - 4.1358
2
R = 0.3179
5
9
4.5
8
4
7
3.5
6
3
y = 0.0457x + 1.9126
2
R = 0.0037
5
2.5
4
2
3
1.5
2
1
1
0.5
0
0
8
9
10
11
12
13
14
15
log of GDP per capita
Rule of Law
Antidirector Rights
Linear (Antidirector Rights)
Linear (Rule of Law)
16
Antidirector Rights
Rule of law
10
What enforcement mechanisms?
Continuum of alternative tools
• Private ordering
– Exception rather than norm
– Unilateral, bilateral and multilateral, with
multilateral mechanisms especially often used in
finance
• Private law enforcement
– Litigation most important tool
• Public law/regulation enforcement
– Traditional view of enforcement
• State-ownership/control
– Has many problems, but may be considered
Private enforcement often works better in
securities markets
Private enforcement and market capitalization
1.6
Stock market capitalization
1.4
1.2
1
0.8
0.6
0.4
0.2
0
-0.2
0
0.2
0.4
0.6
0.8
Private enforcement index
Each point represents one of 49 countries. Data from LLS (2005).
1
1.2
D. Political economy
• Finance in emerging markets: same principles and
industry undergoing similar changes as ROW. However:
– While countries generally benefit from reform and lib., not clear
what pre-conditions are for successful reform
– And some failures. Regulator/supervisor capture major constraint
• Government poor regulator, e.g., more power does harm if checks and
balances missing; minimally paid supervisors unlikely to resist
corruption; securities markets: private better than public oversight
• Often deeper causes: political economy, corruption, etc.
– Limits to what government/regulation can achieve. Rebalance role
of government relative to private sector
– Consider quantity restrictions, to avoid risks, preserve incentives,
but need to avoid negative signals
Ownership concentration and
institutional development
5. Conclusions
• Fundamentals confirmed
– Yet, changing emphasis and adaptation needed
• Level playing field
– More harmonization with increased competition
• Competition policy
– Often missing so far, but more needed and possible
• Consumer protection
– Increased emphasis, more tools and more education
• Role of standards
– Useful to a point, need to evolve, require proper inputs
• Emerging markets challenges
– Fast financial integration requires specific responses
– Better representation in int’nal forums/policy making