Institutional Underpinnings of Financial Sector Development and Reform

A. Financial Institutions and Economic Growth

The literature analyzing the impact of financial development on growth has provided strong evidence that financial development has a positive effect on long-run economic growth.¹⁵ Thus, establishing well-functioning financial markets and financial institutions, which attract savings and channel them to productive investment projects, has been deemed a policy priority for governments. Recently, the research agenda has turned to the question of why many countries continue to be financially underdeveloped (Girma and Shortland, 2004). Although a broad consensus among economists has been reached on the positive relationship between a country’s level of financial development and its rate of economic growth, there is less consensus on explaining the high degree of variance in financial development across countries (Haber, 2006).

The study of financial markets in the overall context of institutions in development is very new but growing. That is, financial development is not solely driven by differences in the general level of economic development (macroeconomic conditions), but also by differences in the rules pertaining to financial systems and their enforcement (regulatory/institutional conditions) (Asogwa, 2006).

In particular, there is a body of theoretical and empirical work that seeks to explain the persistent disparity in financial market development and economic performance across countries by relating it to the capacity of a country’s institutions to protect private property, enforce contracts, and provide incentives for investment (Osili and Paulson, 2004). For instance, Shleifer and Vishny (1997) argue that weak contract enforcement creates incentives for debtors to default, thereby decreasing willingness to lend. Tavares (2002) notes that weak investor protection has significant negative effects opportunities for external finance, which leads to smaller capital markets. Levine (1999) and Levine et al. (2000) also find a relationship between countries that offer better investor protections and more developed financial markets.

Institutional determinants of financial development. According to Tavares (2002), a country’s financial system and its institutional characteristics are deeply rooted in the country’s history and political culture. For instance, the type of financial system that evolves over time is conditioned by the legal system. The comparative rights of individual investors vis-à-vis the state are emphasized differently under different legal traditions, with consequences for financial development. There is also a very close link between the legal and political influences on financial development (Tavares, 2002). Girma and Shortland (2004) classify the various potential explanations posited in the literature of why financial development has been slow in a large number of countries into three interrelated groups: institutional underdevelopment, legal and institutional heritage, and political economy.

According to the first group of studies, financial institutions do not operate in an institutional vacuum. The efficient functioning of a financial system requires respect for the rule of law, a low level of corruption and good contract enforcement. Thus, financial development, like economic development, also relies on good governance. The empirical literature also shows that the relationship between financial liberalization and financial crises strongly depends on the institutional environment in a country. The contention of this literature therefore is that booms and busts in the financial sector and the resulting financial underdevelopment result from governments’ inability to address institutional shortcomings or lack of understanding of the institutional foundations of a sound financial system that lead to badly sequenced reforms.¹⁶

The second group of literature specifically examines the links between law and finance, and identifies a more fundamental problem: some legal systems are simply not well suited to creating the preconditions for financial systems and institutions to successfully develop.¹⁷ This explanation has a static and a dynamic perspective on why financial development, particularly arms’ length finance, depends on how outsiders’ property rights are enforced. Under the “static” view of law and finance, the focus is on the difference in legal traditions regarding the comparative rights of individual investors vis-à-vis the state—that is, common law versus civil law. Common law systems were designed to protect investor property against the Crown, thus creating an environment in which individuals could transact confidently. On the other hand, the state is set above the courts under civil law, and consequently interests of politically connected heads of firms above individual investors. According to this literature, countries that adopted British Common Law have larger financial systems compared to countries that adopted the French Civil Code due to the better protection given to investors under the former system. In this body of literature, either politics and political institutions do not matter (La Porta et al. 1998), or they matter but are less important than legal origin (Beck, Demirgüç-Kunt, and Levine, 2003) (in Haber, 2006).

The “dynamic” view of law and finance focuses on the adaptability of the law to changing conditions, with flexible legal systems deemed as better suited to fostering financial development. Because common law emerges on a case-by-case basis, it can more quickly close the gap between an economy’s needs and the law. This is in stark contrast to the seemingly immutable legal code of French civil law. The more difficult it is to undertake legal reform, the less investor protection there is at the cutting edge of financial innovation, thus tending to slow down financial development (Girma and Shortland, 2004). However, Tavares (2002) notes that country experiences do not entirely accord with this dichotomy—all countries, regardless of legal tradition, adapt to a greater or lesser extent to new economic and contractual realities.

Beck et al. (2001a, 2001b; in Tavares, 2002) empirically show that legal tradition does affect the level of overall financial development. But critiques of this literature also argue that there are some civil law countries that performed very well in terms of financial development in the early 20th century. And even within legal origins, a large discrepancy in terms of financial development exists (Tavares, 2002). Thus, other studies focus on the quality of legal systems, rather than legal origins per se. Results show that the level to which firms are financially constrained is higher when there is a high risk of expropriation, inefficient legal systems and high associated corruption. Modigliani and Perotti (1999; in Tavares, 2002) also argue that, in the absence of a strong legal system that can protect external investors, financial intermediaries with sufficient bargaining power to enforce their rights privately come forward and extract rents.

The third group of studies identified by Girma and Shortland (2004) focuses on the political economy of financial development, and presents a dissenting argument that legal origin has little effect on financial development or on economic growth more broadly. Instead, financial development is an outcome of specific laws and regulations, which in turn are the result of politics and political institutions (Haber, 2006).¹⁸ This view also provides another way of looking at the divergent performance of countries with similar legal systems over time, by looking at the political system in which decisions about economic policies are made. In particular, Rajan and Zingales (2003) propose such a new political economy view to explain the u-shape pattern of financial development during the 20th century; that is, an interest group theory of financial development. They argue that financial underdevelopment may be the result of political circumstances—that is, to protect the interests of a narrow political/industrial elite. Since this group is served well by relationship banking, and potential competitors’ access to finance is restricted by the absence of arms’ length finance, such an elite may have little interest in developing well-functioning capital markets as an end in itself.

The latter two explanations of cross-country variance in financial development—i.e., law and finance and political economy—share two common characteristics. The first one is that they both emphasize that legal origins and political institutions were created through processes that occurred over long periods of time. The implication is that cross-sectional regression analysis is not the appropriate methodology to examine the way these mechanisms actually affect financial development. The second similarity, albeit with some exceptions, is that both explanations tend to focus on corporate governance and the growth of securities markets, i.e. arms’ length finance. However, as Lamoreaux and Rosenthal (2005; in Haber, 2006) pointed out, it was not until the 20th century that firms in developed economies financed themselves through the sale of securities on organized exchanges; a more important source of finance in the 19th century was banks. And what was true for developed economies in the 19th century is true for developing and emerging economies today: few firms raise funds by selling shares on the market. Thus, any discussion of variance in financial development needs to focus at least as much on the development of banking systems as it does on the development of securities markets (Haber, 2006).

For instance, Haber (2006) traced the way the banking systems of the United States and Mexico developed from independence to 1913. His analysis indicates that political institutions—particularly those that created (or failed to create) institutionalized competition among political entities—played a significant role in determining the size and structure of the banking systems in these countries.

Zhang (2006a) used a similar approach in his study on Malaysia and Thailand; that is, he developed an institutional explanation of financial policy choices. In particular, he drew on theoretical studies on the policy impact of political parties to explain cross-national differences in Malaysia and Thailand’s financial policy choices and the resulting capital market structures. His study showed how financial and regulatory policies have varied significantly in response to national configurations of political parties over time in the two countries. And it is this difference in the patterns of policy changes that has shaped financial market structures and development. He makes three major conclusions: (i) the significance of politicians and their preferences, as shaped by political party structures, in the process of policy formation and market development; (ii) political processes of policy formulation shaped by domestic political institutions still strongly influence market structures and development in small, open developing economies, even with the most intensive harmonizing pressures generated by global market integration; and (iii) political institutions in general and political party structures in particular matter significantly in the process of financial market development and governance. Thus, the paper confirms the tight linkages between political parties, incentives structures, and policy and market outcomes. Explaining national patterns of financial policy choice and performance, and the dynamics of capital market development, then requires that such linkages be explicitly addressed.

Financial liberalization/reform. Girma and Shortland (2005) also noted that the importance of countries’ political regime characteristics has largely been ignored in studies on financial liberalization. Most studies have focused primarily on the effects of financial liberalization on financial stability and economic growth, rather than its causes. Research on the political economy of financial liberalization, on the other hand, is mostly case studies. Finally, Girma and Shortland (2005) note that empirical research on the domestic and systemic causes of liberalization primarily relates to capital account liberalization. Thus, they conducted their own study on reasons for financial development or underdevelopment by empirically examining if regime characteristics such as a country’s autocracy/democracy characteristics determine whether financial development is impeded through financial repression.¹⁹

Their results indicate that the countries most likely to have fully liberalized financial systems are the highly democratic countries. However, a regime has to be fully democratic to have a positive impact on liberalization. The results would seem to indicate that governments in intermediate regimes (that is, neither fully autocratic nor fully democratic) use financial intermediaries to pay off their supporters. In contrast, fully autocratic regimes would have more direct ways of dealing the opposition, rendering such policies unnecessary. Thus, the paper concludes that “elites, which are neither fully entrenched nor subject to intense electoral competition, act as a barrier to financial development. Governments appear to have deliberately used policies of financial repression in the banking system and controls on capital account transactions to control who receives financial resources and escape international scrutiny of their policies” (Girma and Shortland, 2005: 24).

Zhang (2003) also related political structures and liberalization in the Republic of Korea; Singapore; Taipei,China; and Thailand. He noted that these economies pursued different liberalization strategies during the 1980s and 1990s, which he attributed to differing domestic political structures. In particular, he argued that their divergent liberalization approaches and outcomes was due to fundamental differences in the organizational structures of the private sector, the bureaucracy and the party system, which shape social groups and state agencies’ economic interests and political behavior in the policy-making process. As a result, they also had contrasting performance in the recent financial crisis. The growing capture of the policymaking process by the politically resourceful and structurally powerful industrial and banking groups led to the failure of market reform in the Republic of Korea and Thailand. In contrast, industrial fragmentation in Singapore and Taipei,China weakened private actors’ capacity to organize effective group-based lobbying, and hence influence the reform process. The capture problem in the Republic of Korea and Thailand also reflected the inability of key state financial and regulatory agencies to insulate themselves from particularistic interests. Singapore and Taipei,China’s respective central banks enjoyed a relatively high degree of political autonomy and organizational cohesion, which enabled them to manage financial market reform more effectively. Thus, Zhang underscored the importance not just of putting in place optimal policy and regulatory frameworks, but also of developing and improving in a sustained manner the political institutions that can bring about the desired public policy objectives. Again, the point is that without the appropriate political and institutional preconditions, financial market liberalization is likely to run counter to its proponents’ objectives.

The political economy explanation for financial underdevelopment and the overall disappointing impact of financial liberalization also applies to the Philippines. In particular, Hutchcroft (1998) provides a detailed history of the Philippine commercial banking system from the American colonial period, when the combination of weak state and powerful oligarchy began to emerge, up to the Ramos administration in 1992–96 when important reforms to liberalize and privatize key sectors of the economy were undertaken. A crucial development in the banking system during the postwar years was the entry of a new “breed” of commercial bankers into the system. With the government's promotion of import substitution industrialization, prominent families began to move into various industrial activities. Ownership, or control of, or affiliation with a bank was seen as imperative to provide inexpensive credit for other parts of the conglomerate. As a result, almost all prominent families had ventured into commercial banking by 1965 (Patrick and Moreno, 1984; Hutchcroft, 1991). Furthermore, it was at their instigation that the government asked the IMF-World Bank mission, which was conducting a review of the Philippine financial sector in 1979, to look into the possibility and consequences of expanding the functions of financial institutions, for instance allowing commercial banks to undertake investment banking functions. Simply put, patrimonialism adversely affected national policy towards the banking sector, which in turn had adverse effects on financial intermediation and ultimately growth.

B. Institutional Underpinning of Financial Governance Reforms

In the aftermath of the Asian financial crisis, the recommendation particularly of the international financial institutions was essentially domestic in nature: the upgrading of the domestic economic governance framework through convergence on international “best practice,” as set out in the various international standards and codes. The Washington Consensus had emphasized the combination of macroeconomic stabilization, and trade and financial liberalization, with no mention of the institutional/governance requirements of financial openness. After the Asian crisis, there was significant emphasis on institutional and governance reforms, including the upgrading of prudential regulatory frameworks. However, this was not seen as a rejection of the Washington Consensus, but as a way of augmenting it. In particular, financial liberalization was still promoted as welfare enhancing, albeit with the additional proviso that an effective prudential regulatory framework must also be in place (Walter, 2002).

Mishkin (2001; in Walter, 2002) notes the wide coverage of the new consensus with respect to “governance requirements.” For financial liberalization to work and to make financial crises less likely, the necessary institutional/governance prerequisites include: (i) adequate prudential supervision; (ii) high accounting and disclosure standards; (iii) effective legal and judicial systems; (iv) the facilitation of market-based discipline through entry and exit policies, competition policy, etc.; (v) reduction of the role of state-owned financial institutions; and (vi) elimination of too-big-to-fail in the corporate sector. The various structural conditionalities attached to the IMF-led rescue packages for Thailand, Indonesia and the Republic of Korea clearly reflected this new agenda (Kapur, 2001, Goldstein, 2001; in Walter, 2002).

Governance and financial regulatory agencies. Governance is a concept that has developed considerably since it emerged in discussions of development issues around the late 1980s. Most international organizations and bilateral agencies have developed their own definition of governance. Asian Development Bank (1998) defines the concept as the manner in which power is exercised in the management of a country’s social and economic resources for development. The World Bank uses the same definition. The United Nations Development Programme (UNDP), on the other hand, defines governance as the exercise of political, economic and administrative authority to manage a society’s affairs. A formal definition of governance was also presented in the recent European Commission White Paper on European Governance (Commission of the European Communities, 2001); that is, governance means “rules, processes and behaviour that affect the way in which powers are exercised at European level, particularly as regards openness, accountability, effectiveness and coherence” (p. 8).

Kaufmann et al. (2002: 10) define public sector governance as "the traditions and institutions that determine how authority is exercised in a particular country. This includes (1) the process by which governments are selected, held accountable, monitored, and replaced; (2) the capacity of governments to manage resources efficiently and to formulate, implement, and enforce sound policies and regulations; and (3) the respect of citizens and the state for the institutions that govern economic and social interactions among them." This definition is, by extension, also applicable to appointed bureaucracies and official agents, including financial sector regulators. Regulatory governance, which is a more specific concept, refers to the efficient and effective application of governance in the area of regulation. (Ferris, 2001). It encompasses the whole system by which regulation and competition are managed to achieve societal goals. (Cariño, 2002).

Das and Quintyn (2002) use the term regulatory governance to refer to “institutions that possess legal powers to regulate, supervise and/or intervene in the financial sector” (p. 7). They argue that good regulatory governance in the financial system is a critical component of financial stability. It is needed to promote effective competition in the companies being regulated, as well as facilitate the on-going process of change and provide the public with an efficient supply of services at reasonable prices. By failing to apply good governance principles, regulatory agencies lose credibility and moral authority to promulgate good practices in the institution under their oversight. This could create a moral hazard problem, contribute to unsound practices in the markets, and, ultimately, accentuate crises in the financial system. And a key aspect is that sound governance practices are also established and practiced by the regulatory agencies themselves. In fact, most of the financial crises of the past decade involved political interference in the regulatory and supervisory process, forbearance, and weak regulations and supervision. All these are symptoms of weak regulatory governance.

According to Das and Quintyn, good regulatory governance has four components— independence, accountability, transparency and integrity. Independence relates to independence from the political sphere and from the supervised entities. The issue has been raised as to why politicians would choose to delegate tasks related to economic and social regulation to an independent agency, rather than to a government agency, a specific ministry, or a local body. Das and Quintyn note two advantages of the former over the latter: expertise can be resorted to and relied on, especially when complex situations arise; and to safeguard market intervention from political interference, which would improve the transparency and stability of the outcome. That is, the possibility of making credible policy commitments would be enhanced by agency independence.

Credible policy commitments also have to do with the time-inconsistency problem. That is, political executives find it very difficult to credibly commit to long-term strategies and solutions due to the short-term cycles of elections and term limits. Another commitment problem that they are faced with is that they cannot bind a subsequent legislature and government. This makes public policies vulnerable to reneging, and would therefore lead to a lack of credibility (Majone, 1997; in Das and Quintyn, 2002).

However, the need for political independence has also raised concerns that independent agencies would be outside political control, not be politically accountable, or pursue their own agendas that may go against the agenda of the political majority in democratic regimes. Independent regulators have sometimes been referred to as the “fourth branch of government,” implying that they are outside the control of the traditional three branches that, through checks and balances, keep mature democratic systems in equilibrium. Such concerns are deemed as justified. Thus, it is also argued that independence should go hand in hand with accountability, particularly with respect to delegating authority (the government or the legislature), to those who fall under their functional realm, and to the general public. In practice, though, implementing it is more complex. If the agency’s objective is clearly defined and measurable, implementing accountability would be straightforward. But financial supervisors typically have several broad objectives, such as preserving financial stability or consumer protection. Thus, it would be more complicated to hold them accountable for achieving such objectives, compared to a central bank whose main objective is to meet an inflation target, for instance.

Transparency in monetary and financial policies refers to the way in which objectives, frameworks, decisions and their rationale, data, and other information, as well as terms of accountability are released to the public in a comprehensive, accessible, and timely manner. Finally, integrity means there are mechanisms to ensure that the staff of the agency does not compromise the pursuit of institutional goals in favor of their own behavior or self-interest. Integrity needs to be pursued and safeguarded in four levels: (i) the integrity of the board- level appointees (policy making body) in terms of procedures for appointment of heads, their terms of office, and criteria for removal; (ii) integrity of the agency's day-to-day operations; (iii) standards for the conduct of personal affairs of officials and staff to prevent exploitation of conflicts of interest; and (iv) the staff of the regulatory agency enjoys legal protection while discharging their official duties.

Independent regulatory agencies. The case for regulatory and supervisory independence has been well established in the case of public utilities, and other economic sectors where sector-specific oversight is required due to externalities. In the financial sector, the arguments are well established for central bank independence. On the other hand, the focus on financial sector regulatory and supervisory independence is fairly recent, and hence the discussion is not as extensive. Recent interest is due to two factors: (i) in most of the systemic financial sector crises that occurred in the 1990s, the lack of independence of supervisory authorities from political interference was cited as a contributing factor; and (ii) recent discussion on the most appropriate financial regulatory and supervisory structure.

In particular, Quintyn and Taylor (2002) make two contentions. The first is that a substantial degree of independence is needed by bank regulators and supervisors to fulfill their mandate and help to achieve and preserve financial sector stability. The second is that it is a complement to central bank independence in order to achieve and preserve the twin goals of monetary and financial stability. They also distinguished between “goal independence” (which refers to the regulatory agency’s mandated objective) and “instrument independence” (which refers to the actual formulation and implementation of supervisory and regulatory practices left to the discretion of specialist officials). They note that the politicians’ proper role is to set and define regulatory and supervisory objectives, but the regulators must be given the autonomy to determine how they should achieve those goals—and the accountability if they fail to achieve them. Finally, Quintyn and Taylor identify four dimensions of instrument independence—regulatory, supervisory, institutional, and financial or budgetary independence. The first two are characterized as the core functions, while the latter two are essential to support the execution of the core functions.

Regulatory independence means the agency has an appropriate degree of autonomy in setting technical rules and regulations, within the general confines of the law. Of the four dimensions, this is the most crucial but it is also the most difficult to implement in some countries because of the way it impinges on fundamental issues embedded in the constitutions and often rooted in long legal traditions.

The supervisory function is divided into four activities: licensing, supervision, sanctioning, and crisis management (Lastra, 1996; in Quintyn and Taylor, 2002). Ensuring the integrity of the supervisory function is typically undertaken through legal protection for bank supervisors/examiners, rules-based system of sanctions and interventions (e.g., prompt and corrective action), and appropriate salary levels and clear career paths. Supervisory independence is also critical for financial sector stability, but it is also difficult to establish. Government interference, especially under the form of forbearance, is still common in many countries.

Institutional independence refers to the status of the agency as separate from the executive and legislative branches of government. It includes three critical elements: terms of appointment and dismissal of senior personnel; governance structure; and openness and transparency of decision-making. Finally, financial or budgetary independence refers to the role of the executive/legislature in determining the size and use of the agency’s budget, including staffing of the agency and salary levels. Budgetary independence from government may enable financial supervisors to better withstand political interference, but it may lead to industry capture if the agency depends on the industry instead.

Quintyn and Taylor (2002) also note that arrangements for agency independence are by themselves not sufficient for effective regulation and supervision. Existing institutional arrangements and political culture are also significant. They highlight the need for checks and balances in the government system for independence to work. In particular, it would be relatively easy and less costly for authorities to override or undermine agency independence if there are few checks and balances. Some studies have shown this to be true in the case of central bank independence. Since this is the political reality in many developing countries, Quintyn and Taylor (2002) point out that governments need to be convinced through other means not to interfere with the financial sector. One such way would be through adherence to international standards and best practices. Carmichael and Kaufmann (2001) also argue that the Core Principles issued by the various international financial institutions are good guides, and they are the principles to which every regulator should aspire.

Political underpinnings of financial market governance. Walter (2002) described the core element of the IMF packages for the crisis economies in Asia as a move away from a system of financial regulation that is highly “relational-patrimonial” in nature towards a western-style “rules-based” system of prudential regulation and supervision. That is, under the former type of regulatory environment, banks typically constitute a kind of protected oligopoly. And given their centrality to the domestic financial and political system, they are deemed as too important to fail (Rosenbluth and Schaap, 2002). Close relationships between banks and bank regulators are also typical, making regulation more relationship- based than rules-based.

Thus, Walter argues that formally converging on international standards and codes is the easy part. But under this reform strategy, the likelihood of implementation failure is significantly underestimated because it does not take into account regulatory forbearance, which remains chronic in many of the East Asian countries undertaking such reforms. Implementation failures occur when politicians may have strong incentives to supply the regulatory forbearance demanded by weak banks and debtors. Thus, policy sequencing remains perverse mainly for political economy reasons, which leads to continuing financial vulnerabilities for these countries. In particular, real implementation failures mean that prudential regulation will dangerously lag the process of financial liberalization. Walter then illustrates this point by looking at bank capital adequacy in Indonesia, the Republic of Korea and Thailand as a specific area of regulatory forbearance. He then notes how non- transparent real bank capital is even in the best case scenario represented by the Republic of Korea. Thus, he concludes that while convergence towards western regulatory standards has formally taken place, in practice there is still significant divergence due to regulatory forbearance in countries with unresolved financial and corporate sector problems. Ultimately, the key obstacle to the upgrading of financial sector governance in most of East Asia is implementation failure, more than the blocking of key reform legislation.

It could be argued that ‘transition problems’ are inevitable and that the standards and codes exercise will eventually produce beneficial outcomes. But according to Walter, this view is complacent and does not take account of the political economy factors that are likely to produce a continued forbearance gap in many developing (and developed) countries. He also notes that even the international financial institutions, which have the responsibility to monitor and enforce the implementation of the standards and codes, may have mixed incentives to do so in practice.

Zhang (2006b) makes a similar argument. He notes how the IMF and the World Bank’s current reform agenda emphasize the role of institutions in promoting market discipline and getting the institutional mix right for financial systems to function smoothly, but still in the context of privatization and liberalization. According to Zhang, this financial market governance paradigm, which has achieved the status of a new orthodoxy in the international policy community, has three key components:

1. To ensure financial stability, the state is expected to play an active role in building strong legal and regulatory systems, while at the same time nourishing the financial market as an institution to maximize the scope for voluntary transaction. Thus, governments are urged to privatize state-owned banks, abstain from directing credit, and secure the rights of creditors and shareholders;
2. Free from government intervention, the financial market is supposed to encourage private actors to participate in market relations that stimulate financial development. This is to give significant scope for self-regulatory organizations and market regulations to “become a central institution of financial governance, a key institution for amplifying supervisory structures, facilitating information flow, allocating resources and managing risks.” That is, instead of depending on the state to fulfill these function, private participation and regulation are presented as the responsible market-based alternative; and,
3. Good governance must be predicated upon the building of concomitant institutions— credible legal systems, independent monetary agencies, active capital markets, and transparent and harmonized regulatory structures.

Zhang recognizes the new paradigm’s novel form of institutional rationality for the existence of efficient financial systems. That being said, he argues that it still has vital limits, particularly its failure to address the political dimensions of financial market governance. To wit:

The newly found state-friendly discourse has been framed in narrow economic terms as the supply of legal and regulatory institutions. It negates the much broader role of the state in market governance in developing countries and neglects the political process through which state actors create and regulate the financial system. Despite its emphasis on governance, the paradigm seldom confronts the issue of government and the politics that underlie it … While the building of new institutions occupies the proscenium arch of the governance agenda, it has paid scant attention to the fact that institutional reforms would tamper with the existing political bargains that involve powerful interests … Equally important, private participation and regulation has been promoted as a crucial institution of financial market governance without much discussion of the real and potential danger of private actors capturing the policy and regulatory process. To the extent that private capture is recognized as a legitimate concern, it is perceived as something that is to be resolved by governance (Kaufmann, 2002), not something that is likely to be a perpetual problem of the process (pp. 170-171).

According to Zhang, any attempt to improve the functioning of developing countries’ financial markets must explicitly aim to enhance the role of state, tame powerful private interests, and promote distributive justice. To him, these are the issues that “constitute the essential political underpinnings of financial policy management and market governance in developing and emerging market countries” (Zhang, 2006b: 191). In particular, the role of the state needs to be strengthened, not only in terms of supplying the effective legal systems but, more importantly, in dismantling old market institutions and creating and keeping new and efficient financial markets and regulatory structures. A politically sustainable balance of power between private interests and public authorities has to be established. The challenge for public institutions then is how to employ private market agents to improve financial governance, and at the same time subject their behavior to the surveillance and control of democratic processes. Failure to fully consider these political and normative dimensions, Zhang concludes, could cause the prevailing governance paradigm, which is increasingly shaping the financial architecture of developing countries, to become politically unsustainable and hence fail.

In particular, the architecture of financial supervision and any need for change also became an important issue to be addressed in the aftermath of the Asian financial crisis. Thus, strengthening the supervisory mechanism under the IMF programs for Indonesia, the Republic of Korea and Thailand also required the establishment of integrated prudential regulators (Gochoco-Bautista et al., 1999). However, to date, only the Republic of Korea has managed to undertake such a reform. Indonesia passed the reform legislation, but implementation has been moved several times. On the other hand, key financial reform legislations were proposed but were subsequently blocked in Thailand. As argued by Walter (2002), one explanation for the delay in the upgrading of prudential financial supervision was precisely that—political institutions allowed vested interests to block the reforms.

But it should also be noted that the feasibility of a unified financial regulatory body in the Republic of Korea (and even more so in the United Kingdom) was first subjected to in-depth studies, analyses and public debate, which then formed the basis for the proposed bill to consolidate all existing financial supervisory authorities. This was not the case in Indonesia or Thailand. That is, lack of understanding and hence appreciation for the reform would have played a part as well.

C. An Institutional Approach to Reforming Financial Regulatory Agencies

Traditional approach to reforming financial regulatory structures. In considering what regulatory structure is appropriate in an integrated financial world, the underlying issue is what regulatory structure minimizes the chances of government failure in ameliorating market imperfections and does so most efficiently (Skipper, 2000). With respect to consolidation of financial sector supervision, some consensus is beginning to emerge. In particular, the literature highlighted two points: changing the regulatory structure must be undertaken only if it will maintain and enhance supervisory capacity and the effectiveness of supervision; and the change in the institutional structure of regulation must reflect the change in the market structure. Abrams and Taylor (2000), for instance, contend that the structure of the regulatory system must reflect the structure of the markets being regulated to be effective. If that is the case, then choosing between the single financial supervisor model (FSA) and multi-financial authorities model (FMA) seems to be straightforward, at least theoretically. Prima facie, the FSA model seems to be the optimal supervisory regime to meet the challenges posed by market-blurring and financial conglomeration. Although Masciandaro (2003) notes that the answer may not that simple.

The literature is generally cautious especially in the application of the approach to developing countries. Thus, each country is encouraged to conduct a full assessment of the pros and cons of adopting a particular model. In particular, the literature on the FSA model versus the FMA model highlights the need for countries to conduct some cost-benefit analysis to take into account specific institutional settings, in order to choose between alternative models. Hawkesby (2000), for instance, identifies a number of factors that policy makers have to take into account when assessing the costs and benefits of a supervisory structure, including: the cost of performing supervision, the efficiency of supervision, the effectiveness of supervision, and the impact of any choice on the conduct of monetary policy. He also cites some country-specific economic factors that may make a particular structure of financial supervision more appropriate compared to other structures. For example, the central bank may need to be responsible for prudential banking supervision for this function to be undertaken effectively and free of political interference in developing countries, especially if the central bank is already an independent one.

Abrams and Taylor (2000) also note that in countries where the financial system includes universal banks or where banks are significant players in the securities markets, then combining banking and securities regulation will be most appropriate. And there may be a case for unified supervision in countries where banks dominate in insurance and securities business. Finally, according to Skipper (2000), moving toward unified supervision would be more complex and difficult the larger the financial services market of a country, and vice versa. Thus, the adoption of integrated financial regulation by a number of transition economies has been justified by the relative smallness of their financial sectors, and hence the economies of scale in regulation that they could achieve (Mwenda and Fleming, 2001).

Hawkesby (2000) does recognize the difficulty of undertaking a cost-benefit analysis due to the degree of uncertainty surrounding the economic costs and benefits. Finally, he noted the significant role that political factors could play in the choice of supervisory structure. These in turn would be influenced by the country’s recent history, public opinion, political inertia, or concern over the amount of power granted to the supervisory authority.

Masciandaro (2003) agrees that while an analysis of the expected costs and benefits from possible alternative structures would be important, it would not be enough to come up with a conclusive decision regarding an optimal supervisory regime. Estimating the real effects, instead of the potential effects, that the alternative supervisory models would have on key economic variables would also be problematic for 3 reasons: (i) measuring the degree of concentration of powers in order to attempt the quantitative description of a qualitative phenomenon would be problematic because of the diversification, from country to country, in the degree of centralization of financial supervisory power; (ii) the issue of the optimal degree of concentration of financial supervisory powers is fairly recent, so there is just a very short historical series available for analyzing the type of supervisory regime as an explicative or exogenous (though not unique) variable of any other economic phenomenon; and (iii) it would be difficult to completely and satisfactorily identify the key economic variables that would be affected by the supervisory structure, and/or how to measure them accurately.

Thus, Masciandaro (2003) concludes that a quantitative search for the effects of alternative supervisory structures is probably premature at this point. Instead, he raises the question of whether there are any common determinants in the decision each country makes to maintain or reform its financial regulatory structure. The answer to this question would help to interpret what has happened in the past, as well as project future scenarios of change. He then proposes an alternative approach to answer this question—that is, he applies to the financial supervision area the classic intuitions of the new political economy using a delegation approach.

Political delegation approach to reforming financial supervisory structures. As argued in the previous section on institutional reform, successful institutions are not easily transferred from one context to another because economic institutions must be supported by appropriate political institutions.

In line with this, Masciandaro (2003) argues that it is not possible to determine a priori the optimal degree of concentration in the financial supervision regime; rather it is an expected variable calculated by the policymakers that maintain or reform the financial architecture. Thus, the approach that he adopts is to treat the supervisory structure with one or more authorities as an endogenous variable, which is in turn determined by the dynamics of other economic and political structural variables that can summarize and explain the political delegation process. That is, what leads a country to either maintain or reform its supervisory structure is the political process.

In particular, his methodology involves combining new political economy and principal- agent/delegation approaches. The thesis that he tests is as follows: the optimal financial supervisory design in a given country depends on structural economic and institutional features. Policymakers then either maintain or reform the financial supervisory architecture, depending on the economic and institutional structure of their countries. The financial supervisory architecture can therefore be treated as an endogenous variable, which depends on a set of medium/long-term features. That is, it is a path-dependent variable.²⁰

Masciandaro’s methodology is similar to that applied to the study of central bank independence, which also represents a search for an optimal structure for the monetary agency. There is significant literature that endogenizes central bank independence, and tries to identify the conditions under which a given country might decide to modify its degree of independence. The various interpretative hypotheses proposed to explain the degree of central independence include the following: (i) financial interest group, i.e., the degree to which constituencies strongly averse to inflation are present as a political interest group, which drives policymakers to strengthen the status of the central bank; (ii) political interest group, which argues that features of the legislative and/or political system can influence the policymakers’ decision to have a structure of monetary powers with an independent central bank; (iii) specific public interest, which argues that establishing an independent central bank may be due to policymakers’ specific interest for reasons linked to political stability or international credibility; and (iv) general public interest, which emphasizes the role of the culture and of the tradition of monetary stability in a country or the importance of the citizen preferences.

Finally, Masciandaro (2003) uses the principal-agent approach to analyze the endogenization of the policymaker's choice of the optimal level of concentration in the supervisory architecture as a delegation problem. He notes that principal-agent models have also been applied to monetary policy studies. That is, to make the conduct of anti-inflationary monetary policy more effective, it is in interest of the policymaker (the principal) to delegate it to an independent central bank (the agent).

To apply the principal–agent approach to the issue of optimal financial supervisory model, Masciandaro (2003) proposes four steps: (i) identify the policymaker’s objective in choosing to delegate the supervisory policy over the banking, securities and insurance system; (ii) explain why the policymaker wants to delegate this policy rather than directly implement it, and if his choice is motivated by general or specific interests; (iii) ask how many institutions the policymaker delegates this policy to; and (iv) which institution(s) he employs.

After defining the theoretical framework of the endogenous supervisory regime, Masciandaro then raises the following empirical question: are there common cross-border economic and/or institutional structural variables that explain why a country chooses or rejects a given supervisory model? If common economic and institutional endowments are associated with a given supervisory regime, then the probability that this model will be adopted in a specific country will depend on the presence of these endowments.

Masciandaro starts his analysis by constructing a Financial Authorities Concentration Index (FAC index), based on an analysis of which and how many authorities in 69 countries²¹ are empowered to supervise the three traditional sectors of financial activity (banking, securities markets, insurance). A numerical value is then assigned to each type of authority: the higher the concentration of supervisory powers, the higher the value of the index value. This means the index reaches its maximum level if there is a single authority, and the minimum when there are more than three supervisors. The scores of the countries in his sample indicate that concentration of powers of financial supervision is more a feature of the developed countries than the developing or emerging states, particularly in Europe. However, he also notes that the score of four emerging economies involved in Europe’s enlargement process (Estonia, Latvia, Malta and Hungary) reached the maximum level of FAC index.

He also calculates the Central Bank as Financial Authority Index (CBFA Index) to capture the involvement of the central bank in financial supervision by assigning a numerical value to the extent of the central bank’s financial supervision function: the more sectors the central bank is involved in, the higher the index. This time, an analysis of the scores showed the central bank involvement in financial supervision is more characteristic of the developing and emerging countries. Taken together, the results showed that two polarized models are the most common: countries with a high concentration of powers with low central bank involvement (Single Financial Authority Regime); and countries with a low concentration of powers with high central bank involvement (Central Bank Dominated Multiple Supervisors Regime), which is consistent with a “leader–followers” framework.

Applying the political delegation approach to the results of the descriptive analysis indicates two things: (i) the policymakers around the world choose to delegate financial supervision rather than implement it directly; and (ii) the political choice on the degree of supervision consolidation seems to be negatively related to central bank involvement in financial supervision. Masciandaro posits two possible explanations for the trade-off between supervision consolidation and central bank involvement. One is the fear of over extension of the financial safety net if the central bank is also involved in the supervision of the securities and insurance sectors. Two is the fear of creating an overly powerful agency, which is a political economy explanation.

To determine the relationship between the policymakers’ decisions regarding financial architecture and given country economic and institutional characteristics, Masciandaro then estimates a model of the probability of different regime decisions as a function of the following structural variables: (i) the structure of the financial systems itself (i.e., private governance factor); i.e., whether it is bank-based or market-based, and a measure of the size of the securities market size relative to GDP, to capture the size of the market and the role of financial conglomeration; (ii) the institutional environment (i.e. the public governance climate) to determines the ability of the policy makers to implement their choices, which is measured by a summary index calculated using the indicators proposed by Kaufmann et al. (2003); and (iii) the CBFA index, to capture the role of the central bank in the financial architecture.

The expected sign of the relationship between the degree of supervision consolidation and the private governance factor is undetermined. The blurring process means potential changes in the nature and in the dimensions of intermediaries (the financial conglomerates effect). In a bank based regime, if the policymakers’ choices depend on the features of their own regime, a positive relationship between the kind of regime and the degree of financial supervision consolidation, in the context of financial conglomeration, can be posited. At the same time, however, the blurring effects mean potential changes in the nature and in the dimensions of the financial markets (the securitization effects). Thus, in a market based regime, a positive relationship can be expected between the kind of regime nature and the degree of financial supervision consolidation, in face of the securitization effect.

The expected sign of the relationship between the degree of supervision consolidation and the public governance factor also cannot be determined a priori. If a policymaker, regardless of the financial regime of his country, can choose a higher degree of supervision consolidation to improve the capacity to deal with the effects of the blurring process, then a positive relationship between good governance indicators and financial supervision consolidation can be expected. However, if a policymaker prefers a single financial agency to improve his capacity to capture the financial supervisory structure, then a positive relationship can be posited between bad governance indicators and the financial supervision consolidation.

Finally, given the two possible explanations for the tradeoff between supervision consolidation and central bank involvement (i.e., the fear of over extension of the financial safety net and fear of creating an overly powerful agency), Masciandaro posits a negative relationship between central bank involvement and financial supervision consolidation.

The results show that the probability of a country moving towards a Single Financial Authority model, is higher: (i) the lower the involvement of the central bank in financial supervision; (ii) the smaller the financial system;²² (iii) the more equity dominated the private governance model; and (iv) the more the public governance is good.

Institutional quality and financial supervisory structure. In particular, an institutional environment characterized by good governance seems to facilitate the choice of policymakers to unify supervisory powers. According to Masciandaro, a policymaker who cares about soundness and efficiency may prefer the single financial authority in the face of financial conglomeration. Another hypothesis that he posits is that good governance could be just a proxy of deeper institutional factors. This seems to be a very likely explanation. As the experience of the countries that have successfully adopted the single regulator model show, the transition from individual agencies is a complex costly process that has to be managed carefully and effectively. And a range of administrative and personnel issues must be addressed, which must be done again in the context of a well managed change program (Taylor and Fleming, 1999). This indicates that an effective government and high regulatory quality already have to be in place to manage the transition successfully. Or in the case of emerging markets that adopted the single regulator model, especially Estonia, the reform was part of a bigger reform to bring about a more effective government.

As a cursory exercise, one-factor analysis of variance was used to determine the correlation between financial supervisory structure and the various indicators of institutional quality discussed earlier. That is, institutional quality is the response variable while financial supervisory structure is the factor variable with three levels based on Table 1: single supervisor; agency supervises two types of financial intermediaries; and multiple supervisors with at least one each for banks, securities firms and insurers. Appendix 4 shows the results using key components of the Index of Economic Freedom of the World (EFW) and the World Bank governance indicators as response variables. All the results indicate that that there is a significant difference in institutional quality among countries depending on the financial supervisory structure. In particular, institutional quality among countries with a single supervisor is higher than those with agencies supervising two types of financial intermediaries, or those with multiple supervisors. On the other hand, there is no significant difference in institutional quality among countries with agencies supervising two types of financial intermediaries, and those with multiple supervisors.

For instance, using government effectiveness and regulatory quality, which are both components of the public governance index calculated by Masciandaro, as response variables indicate that the average index among countries with a single supervisor is higher by 0.73 and 0.59 compared to countries with an agency supervising two types of financial intermediaries and with multiple supervisors, respectively. Using the legal system and property rights component of the EFW index as response variables indicate that the average index among countries with a single supervisor is higher by 1.76 and 1.36²³ compared to countries with an agency supervising two types of financial intermediaries and with multiple supervisors, respectively. Comparable results when the overall EFW index is used are 0.55 and 0.48, respectively.

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