The Implications of Financial Regulatory Structure and the Current Financial Turmoil

The previous two sections showed that an integrated financial regulatory structure did not necessarily help commercial banks in the PRC; Hong Kong, China; Singapore; and Taipei,China mitigate the impact of the current global financial crisis. Although Singapore and Taipei,China operate under an integrated structure, banking performance in these economies were not better than in the PRC or Hong Kong, China, which have fragmented structures.

In June 2009, both the US and EU proposed extensive financial regulatory reforms in response to the global financial crisis. These countries also operate under fragmented regulatory structures The US proposal recommended the creation of a new federal government agency, the National Bank Supervisor (NBS), to conduct prudential supervision and regulation of all federally chartered depository institutions, and all federal branches and agencies of foreign banks. This agency would take over the prudential responsibilities of the Office of the Comptroller of the Currency (OCC). This office currently charters and supervises nationally chartered banks, federal branches, and agencies of foreign banks, as well as holds responsibility for the institutions currently supervised by the Office of Thrift Supervision (OTS), which supervises federally chartered thrifts and thrift holding companies. The Federal Reserve Bank will have greater power to oversee large financial institutions whose failures could threaten the stability of the entire financial system. Furthermore, the Consumer Financial Protection Agency (CFPA) was established to protect consumers of credit, savings, payment, and other consumer financial products and services, as well as regulate providers of such products and services.

Securities and options are regulated by the SEC, while futures contracts are regulated jointly by the CFTC and SEC. All advisers to hedge funds (and other private pools of capital, including private equity funds and venture capital funds) whose assets under management exceed a modest threshold, should be required to register with the SEC under the Investment Advisers Act. The advisers should then be required to report information on the funds they manage when it is sufficiently assessed that any fund poses a threat to financial stability.

In June 2009, the European Commission put forward its framework proposal on Financial Supervision in Europe. The proposal covered a set of far-reaching reforms in the current architecture of supervisory committees, with the creation of a new European Systemic Risk Council (ESRC) and European System of Financial Supervisors (ESFS), composed of new European Supervisory Authorities. The ESRC would monitor and assess risks to the stability of the financial system as a whole ("macro-prudential supervision"). It would provide early warning of systemic risks that may be building up, and, if necessary, recommend actions to deal with these risks. The creation of the ESRC would address one of the fundamental weaknesses highlighted by the crisis: the exposure of the financial system to interconnected, complex, sectoral, and cross-sectoral systemic risks. The ESFS would supervise individual financial institutions ("micro-prudential supervision"), consisting of a robust network of national financial supervisors working in coordination with new European Supervisory Authorities. These would be created by the transformation of existing Committees for the banking, securities, insurance, and occupational pensions sectors.

There is no clear evidence to support the argument that an integrated regulatory structure is beneficial to banking performance. But the blurring of boundaries between banking, securities, and insurance challenges traditional financial regulatory structures; Meanwhile, financial globalization and the development of derivatives have made financial markets increasingly complicated. Thus, the traditional financial regulatory structure has become inappropriate. In view of the impact of the financial crisis on the global financial market, greater cooperation in global financial supervision needs to be pursued.

Asian countries have adopted a variety of supervisory structures. As reported in Masciandaro (2009), four of the 13 Asian countries operate under an integrated supervisory structure, while the remaining nine countries have fragmented structures.⁴ Similarly in Europe, fourteen of the 27 EU countries have adopted an integrated financial regulatory system, although they have implemented this in different ways. The remaining 13 countries have fragmented structures (Herring and Carmassi 2008).

Developing a regional supervision coordination framework for Asia can refer to the Lamfalussy Process in EU. Although this process has been the subject of recent criticism, it is still the most suitable model for pursuing Asian financial supervisory cooperation in its early stage.⁵

The recommendation for the Asian Lamfalussy Process is organized according to four levels that correspond to the usual policy cycle (Figure 25 [ PDF 80.1KB | 1 page ]). The first level constitutes the initial phase of rulemaking, whereby the Asian Financial Stability Dialogue proposes regulations and the Asia-Pacific Economic Cooperation (APEC) decides on these proposals by the usual consensus. The second level committees, composed of representatives from member countries will then be responsible for adopting specific technical rules to implement the framework legislation approved in Level 1. The third level committees, composed of representatives of member countries' financial supervisory agencies, will oversee the consistent day-to-day enforcement of regulations, and will also be charged with drafting implementing powers for decisions reached in Level 2. Finally, monitoring of transposition will be done in the fourth level by the Asian Development Bank.

In order to implement the Asian Lamfalussy Process, communication and coordination at the regional level need to be strengthened. East Asian countries should set up an Asian Financial Stability Dialogue, made up of finance ministry officials, central bankers, and financial market regulators and supervisors to facilitate policy coordination for financial stability and development. The Asian Financial Stability Dialogue could propose a set of ambitious reforms to the regional architecture of financial services committees, with the creation of a new Committee of Asian Banking Supervisors (CABS), Committee of Asian Securities and Futures Supervisors (CASFS), and Committee of Asian Insurance and Pensions Supervisors (CAIPS).

The recommendations that should addressed by the Asian Financial Stability Dialogue include:

Managing short-term international capital flows. The current global financial turmoil has shifted attention back to problems caused by capital flows. The crisis has revived calls for a fundamental reform of the international financial architecture, revolving around proposals for international institutions designed to regulate and stabilize international capital flows. A starting point would be for the Asian Financial Stability Dialogue to discuss measures to manage short-term capital inflows, particularly when financial markets become euphoric and inflows are excessive. Such measures will be more effective if coordinated at the regional level.

Establishing a foreign exchange market coordination framework. The eight member countries in the Chiang Mai Initiative (CMI) are currently sitting on nearly US$ 4 trillion in foreign exchange reserves. Asian countries can enhance the CMI and its effectiveness to achieve a stable foreign exchange market in Asia. For example, ASEAN, PRC, Japan, and the Republic of Korea agreed in Feb. 2009 to multilateralize the CMI and use the swaps to carry out US$120 billion in foreign reserves coordination.

Strengthening the infrastructure of financial markets and financial products. East Asian governments should ensure that the settlement, legal, and operational infrastructure for financial markets and financial products is sound. The Financial Stability Forum (2008) has suggested that regulators should promote central counterparty clearing (CCP) of over-the-counter derivatives to reduce the loss from a major dealer's failure. CCP clearing also reduces the risk of legal disputes from unconfirmed trades. By standardizing and automating the clearing process, CCP clearing prevents confirmation backlogs.

Enhancing transparency and risk management. Regulators should encourage banks to increase transparency through more regular and timely reporting of liquidity, profitability, and capital key indicators, as well as their exposure to developed country counterparties. Given the opaqueness of complex derivative products and a lack of clarity about risk accountability, it is essential to strengthen financial system transparency. Accordingly, authorities should encourage greater disclosure of complex financial products and ensure the “complete and accurate disclosure” of financial conditions by firms. Regulatory standards for liquidity risk management need to be strengthened, particularly for banks that rely heavily on capital market funding. Authorities need to ensure that regulated financial institutions have proper liquidity risk management frameworks, and formulate contingency plans to deal with a disruption in external financing. Close attention is needed to ensure that local banks are properly classifying loans and adequately provisioning against problem loans.

Strengthening financial institution capitalization. Regulators should encourage banks to immediately start raising capital to strengthen capital requirement ratios well above prudential norms. This would send a clear signal to the market that banks are entering the downturn from a position of strength rather than weakness. In the current environment of uncertainty, regulators may signal that systemically important financial institutions will not be allowed to fail. Precautionary public recapitalization schemes should also be ready where appropriate. However, public recapitalization should be approached with the primary aim of strengthening the financial system and promoting needed adjustments, rather than protecting individual institutions or shareholders.

Alleviating a credit crunch. In the extreme case of a credit crunch, authorities should undertake measures to prevent a downward spiral from feeding into the real sector. Providing guarantees on new lending might be a first option, if bank balance sheets and liquidity positions remain sound and the pullback is the result of excessive risk aversion. In addition, credit can be supplied directly to the real economy, either through the public sector buying financial instruments issued by firms or through central bank credit extensions. Avoiding a credit crunch for SMEs, which typically have more difficulty accessing finance even in the boom time, is an important task. To address SMEs' funding constraints, it may be desirable to establish a regional loan facility to expedite funding. Providing support for trade credit is also critical to prevent further trade contractions.

Reforming rating agencies. The role of global rating agencies in contributing to the current financial crisis needs to be assessed. More specifically, there is a need to review the revenue source of rating agencies and the ways in which ratings are used.

The Financial Stability Forum (2008) has recommended ways to enhance the level of information provided to support structured finance ratings; improve the assessment of underlying data quality; and increase discipline in the rating of new products. The report also highlighted the work of the International Organization of Securities Commissions (IOSCO) in setting standards to enhance the quality and integrity of the rating process. In 2008, IOSCO updated the Code of Conduct Fundamentals for Credit Rating Agencies (the IOSCO Code), to address the additional concerns raised by the rating process for structured finance products. The updated IOSCO Code contains provisions to promote enhanced internal conduct of business controls; address concerns over conflicts of interest in the rating of structured finance products; drive more robust assessment of data quality used to produce ratings; and create greater transparency in the methodologies and limitations of credit ratings.

The US SEC and the Committee of European Securities Regulators recently proposed new rules for credit rating agencies. These proposals strongly reflect the new provisions of the IOSCO Code and the recommendations of the FSF. Asian leaders should also encourage sound development and promote the improvement of regional rating agencies, so that regional and global investors can efficiently choose the best investment opportunities in the region.

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