The Impact of the Global Financial Crisis on Capital Flows and Payment Systems

Malaysia has a high degree of economic and financial openness. In 2002, total trade was more than twice the size of the economy, indicating that Malaysia is one of the most economically open nations in the world. A study by the central bank also demonstrated that Malaysia's economic openness increased substantially from 1990 to 2002 (Ooi 2008). The high degree of openness attracted large foreign capital flows into the country, consisting of both trade and non-trade capital flows.

While there were large non-trade capital inflows prior to 1998, during the Asian financial crisis these past inflows, speculative in nature, became capital outflows, leading to instabilities in the domestic financial market. Malaysia's currency, the ringgit, came under heavy selling pressure from speculative trading in offshore markets. Due to the heavy sell-off, Malaysia imposed capital controls and the ringgit was pegged to the US dollar on 1 September 1998, as the government needed monetary autonomy to influence domestic rates to support an economic recovery and so could not devote resources in defense of the exchange rate (Merican 2005).

In March 2001, the central bank unveiled the Financial Sector Master Plan, which charts the financial sector's future landscape. The key theme of the plan is to build resilient and efficient institutions and systems able to face the challenges of financial sector liberalization and globalization. In preparation for this challenge, the government oversaw progressive capacity building and liberalization in the financial sector over the past decade. The New Interest Rate Framework was unveiled on 26 April 2004. Under the new framework, the central bank signals a change in its monetary policy by using the Overnight Policy Rate, which is the target for the average overnight interbank rate; the interbank rates for longer maturities are determined by the market. The ringgit peg to the US dollar ended on 21 July 2005 and the country adopted the managed floating exchange rate system. The ending of the ringgit peg has led to higher volatility in portfolio and other investment capital flows (Figure 7 [ PDF 27.5KB | 1 page ] and Table 2 [ PDF 241.6KB | 2 page ]). The exchange rate volatility also has increased (Figure 8 [ PDF 44.1KB | 1 page ]).

The global financial crisis has affected Malaysia much less than other countries, although foreign capital flows and exchange rates have shown signs of higher volatility. Domestic interbank money rates have been stable and there is no sign of liquidity evaporating (Figure 9 [ PDF 44.1KB | 1 page ]), despite the drastic fall in the liquidity of US money markets and an increase in outflows of foreign portfolio investment capital. The reason that Malaysia has been less affected than other countries by the global financial crisis is due to many underlying factors, such as prudent macroeconomic management, effective supervision of domestic banks by the central bank and significant improvements in the risk management practices of domestic banks. In view of the high degree of openness in the economic and financial sectors, however, the systemic risks of domestic payment systems and financial markets should not be disregarded.

A nation's payment and settlement system will become more interconnected with the global payment and settlement infrastructure as the nation's financial sector's openness increases. Systems can be interconnected in a variety of ways. First, interdependencies arise from direct relationships among systems. For example, central securities depositories and large-value payment systems may establish technical links or account relationships to facilitate efficient delivery versus payment settlement of securities transfers. Similarly, the continuous linked settlement (CLS) system depends on the account relationships that a CLS bank has established with the central banks of countries whose currencies are CLS-eligible to facilitate the funding process that supports the payment versus payment settlement of foreign exchange trades. Second, systems can be interconnected indirectly through the activities of large financial institutions that have settlement activities in several systems or that provide services to several systems, and so create indirect relationships among these systems. Third, interdependencies can also result from the dependence of a number of systems on a common messaging service provider, such as Society for Worldwide Interbank Financial Transactions, or on a common resource, such as a third-party service provider for their information technology systems (BIS 2008). In Malaysia, a direct connection to the CLS system does not exist since the ringgit is not a CLS-eligible currency. An indirect relationship, however, exists between RENTAS and CLS through their relationship with the US$ Clearinghouse Automated Transfer System (CHATS). An indirect relationship also forms between RENTAS and International Central Securities Depositories, such as Euroclear and Clearstream, when these International Central Securities Depositories appoint as their clearing agents in Malaysia domestic depository institutions that are clearing members in RENTAS.

While the tighter interconnection between systems has helped to reduce costs and risk, it also increases the potential for disruptions to spread quickly and widely across multiple systems and markets. This possibility arises when the smooth functioning of one or more systems is dependent on that of another system. For example, if a large-value payment system participant experiences an operational disruption or liquidity shortfall, it may be unable to transfer funds to its counterparties. As a result, other large-value payment system participants may have lower balances than expected. This shortage of funds could prevent these institutions from receiving incoming securities transfers from a linked central securities depository. In this way, a disruption in the large-value payment system could pass to the central securities depositories. This type of interdependency creates cross-system risk between the central securities depositories and the large-value payment system (BIS 2008).

To mitigate cross-system risk due to a liquidity shortfall, the central bank limits membership in RENTAS to principal dealers. Under this system, the central bank appoints selected banking institutions as principal dealers annually based on a set of criteria, including a firm's ability to handle a large volume of transactions, as indicated by its equity balance, secondary market trading volume, and overall risk management capabilities. In addition, in order to manage liquidity and settlement risk, market participants can borrow funds or securities from the central bank, either through repo or reverse repo trades, or through borrowing or lending securities. The central bank also issued a New Liquidity Framework that requires banks to hold a certain percentage of liquid assets to guard against a possible liquidity crisis.

To address the increased potential for disruptions to quickly spread across many interdependent systems, it is important that systems, institutions and service providers adapt their risk management efforts. First, it is important that these stakeholders adopt broad risk management perspectives, and look beyond their direct operations and exposures to identify the broad range of disruptions that might affect them as a result of interdependencies. Second, it is important that systems, institutions, and service providers at the center of key interdependencies have especially strong risk management controls (BIS 2008). Accordingly, the central bank focuses its oversight resources on the RENTAS system since it handles large-value payments that have the greatest potential impact on the financial stability of the country (Bank Negara Malaysia 2007). In managing the systemic risks in RENTAS, the central bank is committed to strict adherence to the international best practices issued by international bodies such as the BIS's Recommendations of the Committee on Payment and Settlement Systems, and the Technical Committee of the International Organizational of Securities Commission for Securities Settlement. In 2007 RENTAS successfully passed a self-assessment to test if its operations—comprising the Interbank Funds Transfer System, the Scripless Security Transfer System and the RENTAS-US$ CHATS system—closely adhered to the Core Principles recommended by BIS. In addition, the central bank, in its efforts to mitigate the risks arising from RENTAS' dependence on other systems, conducted an industry-wide live disaster recovery operation in June 2007.

Since interdependencies allow disruptions to pass among systems through complex paths and with uncertain intensity, interdependencies also call for wide coordination of risk management and crisis management efforts. Cooperation among central banks and other authorities, including on a cross-border basis, is important (BIS 2008). In Malaysia, the major foreign currency settlement risk arises from the ringgit-US dollar foreign exchange trade as it accounts for most of the total payment flows (73.8% of total payment flows in 2006). To minimize US dollar settlement risk, the central bank introduced payment versus payment infrastructure for the settlement of interbank ringgit-US dollar foreign exchange trades through the RENTAS-USD CHATS system in November 2006. Subsequently, the central bank established a cooperative oversight arrangement with the Hong Kong Monetary Authority as the overseer of the USD CHATS system in order to minimize risks associated with cross-border links between RENTAS and USD CHATS. The clearinghouses for exchange traded shares and derivative instruments are not under the regulatory purview of the central bank. Disruptions in these clearinghouses, however, could pose a systemic risk to the financial system. Therefore, the central bank and the Securities Commission planned to enter into a Memorandum of Understanding to outline the specific aspects of the cooperation, consultation and information exchange between the two regulators (Bank Negara Malaysia 2006).

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