Recommendations for Improving Regional Monitoring and Coordination of Financial Regulation

I have argued in this paper that a great deal of work needs to be done at the global, regional, national, and firm levels in terms of improving the regulatory environment, supervision, and “best practices” in the international financial system. So much went wrong during the global economic crisis that it is difficult to give a good summary of priorities in creating a more stable global financial regime. However, to summarize some of the main points of the discussion in this paper:

1. Capital flows are a necessary feature of the international financial system. They bring with them important economic benefits. However, there does exist a potential externality in terms of systemic risk when there are strong capital-flow reversals, something I have referred to as “financial pollution.” Hence, there is a strong case to be made for close monitoring of capital flows in the national economy and taking prudential measures to avoid excessive risks. In Asia, mechanisms have been put in place since the Asian crisis to avoid negative externalities associated with capital flows. These have not been tested recently due to the creditor status of Asian economies; however, the region needs to remain vigilant as its respective financial systems develop.
2. Highly-leveraged but generally unregulated financial institutions in the OECD, including hedge funds, have been important actors in the global economic crisis. These financial institutions have proven themselves able to generate significant systemic risk to the national, regional, and global economy. They need to improve their own in-house value-at-risk models and investment strategies. However, their revealed potential for systemic risk implies that they need to provide greater transparency to markets and regulators and, in my opinion, will ultimately require greater regulation in order to ensure stability. While this is mainly an issue for OECD countries, Asian developing countries also have a stake in the matter, given their potential for disruption of global markets.
3. Credit rating agencies are necessary to the smooth functioning of the global financial system and they will become increasingly important as Basel II is implemented. Their bruised reputation due to the global economic crisis, in the form of poor valuation of structured products and “conflict of interest” issues, suggests a pressing need for their reform in order to ensure that they can play their necessary role effectively in the modern financial system.
4. In order to improve the global regulatory and supervisory environment, I have delineated a number of issues that need to be addressed, including better information dissemination and transparency, improved cross-border arrangements for financial transactions, better early-warning systems and macroeconomic monitoring, new mechanisms to improve the “procyclical” nature of financial adjustments during crises, and the need to address the “too big to fail” issue.
5. In terms of early warning systems and macroeconomic surveillance, I noted that it is not sufficient just to identify emerging problems: there must be a system in place to deal with them. This is not an easy task, as it involves tackling the “burden of adjustment” problem. Regional economic cooperation can help in this area as it can facilitate concerned responses to emerging problems.
6. I have made the case for stronger financial institutions in Asia. Given the growth trajectory of Asian economies and the importance of finance to the future development of the region, I suggest that this needs to be a priority. Moreover, the global economic crisis underscored the problems associated with relying largely on financial intermediation outside the region. Once again, regional cooperation can help in this regard.
7. I also support the view that an AFSD could help the region address many issues of interest to the region's economies in terms of improving financial stability, fostering development, and helping Asia project its positions more forcefully in international forums. Moreover, I suggest that emerging issues related to financial cooperation, coordination, and integration should be one of the key areas that the AFSD should include in its modus operandi.
8. But there are many other possibilities. As Asian economic cooperation and integration proceeds apace, the region will require additional means of boosting intra-regional trade, investment, and financial flows. In the area of finance, the CMIM and the ABF are two first (small) steps in this direction and others are in the works, and at the sub-regional level the ASEAN Economic Community program includes financial-related measures, though it is mainly focused on the real sector. The case for closer cooperation at the regional and sub-regional levels, nested within the context of global forums, is strong and should continue, from concerted measures to strengthen local capital markets to initiatives that facilitate joint issuances of paper instruments.
9. Still, the emphasis needs to be placed on national financial development. While the financial systems of developing Asian countries have improved since the Asian crisis, much remains to be done in terms of improving national financial institutions, particularly the banking system. Moreover, I have noted that development and deepening of local fixed-income and equity markets need to be part of this process. While global, regional, and sub-regional initiatives can help accomplish this, the most important reforms will have to be undertaken at the local level.

The global economic crisis has taken a horrific toll on global and regional economies. Thankfully, it would appear that I have seen the worst of the crisis. As of late 2009, most indicators point to the beginning of a sustained recovery.

But policymakers need to learn from this crisis and put in place a more stable, resilient international financial regime. The financial boat has revealed many leaks that need to be repaired if it is not to sink when the next storm hits it. Our economic captains have to be vigilant and forward-looking even if it looks like smooth sailing as the world recovers in 2010.

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