Development of Financial Markets in Asia and the Pacific

August 2009

Abstract

Policies relating to the development of financial markets in Asia and the Pacific should reflect the fact that a significant fraction of the households in this region live in poverty and are effectively out of the reach of even elementary formal banking and financial services such as savings, loans, insurance, etc. The future role of informal network of credit markets that currently serve this population (non-bank financial institutions, NGOs, credit unions, micro-finance institutions, village banks, trade-credit, etc.) must be articulated in any financial development strategy. This will reinforce the positive feedback effects between financial markets and economic growth and stability.

Current credit crisis has demonstrated the need to clearly articulate the design of bankruptcy code, and the design of the capital structure of banks/financial institutions to preclude the threat of costly financial distress by creditors and to ensure that "the first port of call" for capital infusions to banks in "bad states" must be the creditors of the bank, and not the tax payers.

Depository institutions that have access to central banks' emergency funds in "bad states" must be made to credibly transfer capital/liquidity from "good states" to "bad states" either through implementable "state-dependent" capital/liquidity requirements or through explicit pricing of the emergency access facilities to be paid for periodically by banks. Given liquid market signals on credit spreads that are currently available, central banks should give serious consideration to developing policy toolkits to prick "asset price bubbles" before such bubbles have the potential to burst the economy into prolonged economic crisis. The flaws in regulation that have been exposed by the credit crisis, such as lax underwriting standards in residential loans, insufficient "skin in the game" for originating financial institutions in the "originate-to-distribute" model of securitization and off-balance sheet liabilities must be corrected in future developmental efforts.

Central banks should put in place permanent institutions and liquidity facilities that reflect the "credit disintermediation" (away from banks) that has occurred so that the "shadow banking system" is also covered by the central bank's facilities. This will have the effect of lowering the probability of "runs" in shadow banking system, ex ante. The overarching goal in the financial markets development should be to promote transparency of financial markets, while recognizing that financial markets with differing levels of transparency can co-exist to cater to the differing risk/reward needs of entrepreneurs and investors.