Internationalisation of financial services: implications and challenges for central banks
Keynote address by Hervé Hannoun, Deputy General Manager of the BIS, at the 41st Conference of the SEACEN Governors Bandar Seri Begawan, Brunei Darussalam, 4 March 2006.
Mr Hannoun briefly reviews some of the main factors driving the internationalisation of financial services. He also looks at the key challenges facing central banks in acting as a "discipline multiplier" and in leveraging the benefits of market discipline in support of policy discipline.
It is my pleasure to attend this SEACEN Governors' Conference in Brunei and I am honoured to deliver the keynote address at this important meeting. The theme of this morning's session is the internationalisation of financial services. My remarks will focus on its implications for central banks as policymakers in charge of monetary stability and with shared responsibility for financial stability.
The last three decades have seen a period of tremendous change in the financial services industry. Foremost amongst these is the internationalisation of the industry. Services once provided in tightly regulated, domestically oriented and fragmented financial systems are increasingly performed in an open, competitive and global system.
One visible indicator of financial globalisation is the growing volume of cross-border capital flows. Cross-border transactions in bonds and equities now exceed USD 90 trillion annually. Closer to home, another indicator relates to the activities of foreign banks in Asia's emerging markets. Foreign banks' assets in Asia have increased more than fourfold over the past 20 years, to about USD 700 billion. Moreover, whereas cross-border loans once comprised the bulk of these assets, foreign banks today provide a wide range of financial services through a local presence. In fact, locally funded loans now account for more than 50% of foreign banks' assets in the region.
I believe that an important implication of financial globalisation is an ever greater emphasis on market and policy discipline. In a liberalised environment, market participants are able to impose discipline on poorly performing issuers, be they firms making reckless investments or countries pursuing unsustainable macroeconomic policies. Markets, however, can at times act too late and, because of this, their reaction can be too severe. We are all too familiar with the disruptive effect of crises.
The challenge for central banks, therefore, is how to enhance and complement market discipline through policy. For example, policymakers have a key role to play in establishing a well functioning legal, regulatory and financial reporting infrastructure. Furthermore, greater transparency and consistency in the implementation of policy instils greater discipline into private sector behaviour. In other words, policy can leverage the effects of market discipline. From a practical point of view, the impact of policy often takes the form of "buffers", either at the macro or micro level, buffers that are accumulated in good times and absorb the stress in bad times. The appropriate calibration and management of these buffers is a key element of policy in a more open economic environment.
In my remarks today I will first briefly review some of the main factors driving the internationalisation of financial services. I will then turn to the key challenges facing central banks in carrying out this crucial role as "discipline multiplier" and in leveraging the benefits of market discipline in support of policy discipline.
II. Driving factors
So what factors drive financial globalisation? I will highlight three. First, the information flows that underpin market activity. Second, the common standards that guide the production and use of information. And third, the infrastructure that allows market participants to act upon this information.
1. Cross-border information flows
The quantity and quality of information available to market participants and observers have increased dramatically over recent decades. Timely and accurate information that is material to investors' decisions is a necessary condition for the appropriate identification and pricing of risk. Therefore, the explosion in the availability of information has greatly enhanced market discipline and, by extension, the integration of financial activity across both markets and borders.
Advances in communications and computing technology have been at the centre of this explosion. Investors now have ready access to detailed data on fundamentals, prices and valuations. Moreover, these data can be analysed, stored and distributed around the world more quickly and more cheaply than ever before. As a result, physical location is no longer an important determinant of investors' access to information.
The cross-listing of equity securities on international stock exchanges has also boosted the availability of information. The number of Asian companies which have listed ADRs (American depositary receipts) on the New York and London stock exchanges has increased fourfold over the past 10 years. Firms are attracted to the major financial centres by the opportunity to raise capital at a lower cost. Firms which cross-list potentially subject themselves to more demanding disclosure and governance regimes, which enhances transparency and accountability. Through a demonstration effect, it may also raise reporting standards in the home market.
In credit markets, the growing number of credit ratings has facilitated the dissemination and analysis of information. While large banks and other big investors have the resources to do their own credit risk analysis, credit ratings are a vital tool in helping smaller investors to form portfolios diversified across credit quality classes. In recognition of the contribution that rating agencies can make to the development of corporate bond markets, authorities in Asia are making a concerted effort to enhance the visibility and credibility of local rating agencies.
One consequence of the wide availability of information is that investment decisions are increasingly being made on a global rather than a national basis. The so-called "home bias" of investors is dissipating and sector-specific factors, as opposed to country-specific factors, are becoming more prominent drivers of asset prices. In those Asian markets with large microchip manufacturers, for example, price movements are frequently driven by developments in the global technology industry.
2. Common international standards
While information is a necessary condition for the exercise of market discipline, it does not in itself suffice. The information must also be analysed and incorporated into market participants' decision-making process. Here, common standards and codes have a key role to play.
Standards are much like a public good. Once widely accepted, they lower the cost of obtaining and analysing information and strengthen the stability of the financial system. However, the process of establishing standards and promoting adherence to them is cumbersome and expensive.
The Financial Stability Forum (FSF), established in 1999 in the wake of a number of international financial crises, has set up a compendium of over 40 standards that have been developed in the financial area alone, many of them by the committees hosted by the BIS. Therefore, it is no surprise that, in some quarters, there is a sense of "standards fatigue". The exclusive process by which some standards have been developed, without the full participation of Asian countries for example, may add to this sense of fatigue.
Considerable effort is being made to maintain the momentum of reform. The BIS, itself deeply involved in the support of global standard setting, attaches great importance to increasing its interactions with Asian central banks. The IMF and the World Bank are helping countries to assess and address vulnerabilities in domestic financial systems. And to help authorities set priorities, the FSF has designated 12 standards as key to a sound financial system.
One domain where much progress has been made relates to the publication of macroeconomic data by national authorities. Participation in the IMF's Special Data Dissemination Standards and General Data Dissemination System has increased steadily in the Asian region and elsewhere since these standards were established in the mid-1990s. Recent studies have found that subscription to these standards was accompanied in many cases by a reduction in borrowing costs.
Another area of attention has been accounting. Just as differences in language can be obstacles to communication, international differences in accounting standards can be obstacles to cross-border financial transactions. Already almost 100 countries have either adopted or based their own standards on International Financial Reporting Standards. The International Accounting Standards Board is working with national accounting bodies, including the Financial Accounting Standards Board in the United States, to bring the remaining differences into closer alignment, and to foster convergence.
Although the revised capital framework for international banks, known as Basel II, is not one of the 12 key standards identified by the FSF, many countries are preparing for its implementation. Basel II is an example of how local differences can be accommodated within a globally consistent framework. The three pillars on which Basel II is based - minimum capital requirements, supervisory review and market discipline - provide a common framework for prudential supervision across countries. At the same time, however, the alternative approaches for assessing the adequacy of banks' capital, ranging from a simple, standardised approach to the more complex, advanced internal ratings-based approach, allow countries to tailor the framework to suit the specificities of their financial system.
3. Linking infrastructures across borders
This brings me to the infrastructure and institutions that enable market participants to act upon the information available to them, and to interact with one another. Essential components include modern contract law and efficient law enforcement procedures, market regulation, and efficient payment and settlement systems.
Maintaining the domestic infrastructure in good working order is an immense challenge for any policy authority. Connecting infrastructures across borders is an even more daunting challenge.
However, promoting interconnectedness does not necessarily mean standardising infrastructures across borders. In some cases, a global solution may be the most appropriate. For example, in the foreign exchange market the major dealers opted to establish the CLS Bank to reduce foreign exchange settlement risk. But there may well be good reasons to retain the idiosyncratic features of local infrastructures as well. After all, competition among trading, clearing and settlement systems can help to reduce transaction costs. That being said, in many local markets the removal of what may seem to be small impediments to financial activity can go a long way towards furthering regional or global integration.
In summary, cross-border information flows, common international standards and the linking of infrastructures across borders are three main factors driving the process of financial globalisation. Let me now turn to the challenges for central banks.
III.Challenges for central banks
A world of increasingly borderless financial services is one filled with promising economic opportunities. At the same time, it poses a number of challenges to policymakers, and in particular to central banks, in charge of monetary stability and financial stability. In the context of financial globalisation, there are two ways in which central banks address countries' potential vulnerabilities: the first one is building the appropriate buffers, the second - and even more important - one is acting as a "discipline multiplier".
In the 1990s the economies in South-East Asia experienced both the upside potential and the downside risks of financial globalisation. Some salient features of the current global economic environment are reminiscent of the run-up to the Asian financial crisis. Global investors' positive attitude towards risk-taking is driving risk premia down and raises questions as to the possible underpricing of risk. Investment flows into emerging markets have intensified, feeding the compression of spreads as investors chase higher returns. In all, private capital flows to emerging markets in Asia totalled about 140 billion US dollars in 2005, with about 40% of that in the form of portfolio investment. But another feature of the current macroeconomic environment was not present during the run-up to the Asian crisis, namely the very low level of real interest rates and the atypical situation of accommodative monetary and fiscal policies around the globe.
There are other significant differences between the current situation and that of the pre-Asian crisis years. To an important degree, these differences reflect the efforts of the institutions represented in this room to address the challenges of the internationalisation of finance. Monetary policy has been refocused and the management of the exchange rate is now characterised by greater flexibility. A prolonged period of current account surpluses has led to a very substantial accumulation of official reserves. Today, reserves stand at three times the size of short-term external debts of Asian countries, while they were barely sufficient to cover this debt in 1996. Furthermore, financial systems have been through a process of rationalisation and restructuring and have emerged stronger and better able to withstand adverse shocks.
These policies are an integral part of the lessons learned by the international policy community regarding how to address the challenges of financial globalisation. And they will certainly be conducive to a smoother adjustment when the current benign external environment shifts and some of the trends that I highlighted above are reversed. In particular, the building of safety buffers in good times will help cushion the impact of bad times. These buffers play a key role in the design of policies that are focused on the longer-term objective of monetary stability and growth. And this is so regardless of whether they are accumulated at the micro level by individual institutions, or built up at the macro level domestically and internationally.
It is crucial, however, that the building of these buffers does not cause policymakers and market participants to lose sight of the central principle transcending these lessons. This central principle is the role of discipline, be it the disciplinary effects of international market forces, the strengthening of the effectiveness of market discipline by prudential policy actions, or the disciplined conduct of sound macroeconomic policy.
What are the ways in which policy discipline can act as a discipline multiplier by harnessing, complementing and enhancing the disciplinary forces of the market? And what is the role of buffers in this process? To address these questions, I would like to focus on two dimensions of particular interest to central banks: monetary stability and financial stability. I would also like to further distinguish between efforts that are domestically oriented and those that involve international cooperation.
1. Monetary and exchange rate policy
Keeping one's macroeconomic household in order is the single most important precondition for a stable financial sector. This old lesson is all the more important in a liberalised environment where financial flows can easily reverse direction, and capital flight can easily follow in the wake of the first signs of domestic weakness or stress. Credible, consistent and forward-looking monetary policy strategy and tactics are key in this effort. In many countries the monetary policy framework has been redesigned to make price stability the dominant objective and allow for greater exchange rate flexibility. This has helped to anchor inflation expectations and inspire prudent private decision-making.
The 1997-98 crisis nurtured the perception that Asian economies needed to build up much larger official foreign exchange reserves to survive in a world of mobile international capital. Building up reserve buffers against disruptive pressures on the national currency became an important policy priority often portrayed as "self-insurance". Reserves accumulated by the Asian economies (including Japan) are now five times as large as those of all other industrial countries.
But large and growing international reserve accumulation can also create challenges for central banks. One is the weakening of monetary control. At first, interventions can be fully sterilised. But as reserves grow, it becomes more and more difficult to sterilise successive increases. If reserve accumulation does indeed result in monetary expansion, it can set off an unsustainable credit boom, or contribute to inflated equity and property prices. Moreover, the accumulation of reserves in the form of conservative investments in low-yielding securities is expensive if compared to the higher yields that foreign investors enjoy in their portfolio investments.
Hence, a question that arises in this context is whether current levels of reserves are an (expensive) insurance against possible capital account reversals or whether they are an unintended consequence, a mere by-product of exchange rate management. A related issue pertains to the impact of reserve accumulation on policy discipline and to whether the insurance function can be thought of as shielding unsustainable policies from the scrutiny and pressure of market forces. Building up abundant foreign exchange reserves cannot be viewed as a substitute for sound macroeconomic policy, including fiscal discipline.
2. Prudential policy
Monetary stability is a necessary, but by no means a sufficient, condition for financial stability. It needs to be complemented by prudential policy and the use of the associated chest of instruments.
Dealing with the stability of a financial sector open to international markets and competition places a premium on policy tools designed to work with the grain of market forces rather than against it. Tools based on the premise of segmented markets and sectors are ineffective and may even be counterproductive if financial intermediaries can circumvent local market restrictions by shifting risks and channelling transactions in imaginative ways. Progress made in this dimension of policy also places emphasis on the role of instilling the proper incentives for market participants to behave with discipline. Indeed, market discipline is not only the discipline imposed by markets, but also the discipline imposed on market participants by the policy framework. In doing so, policymakers rely on the design of buffers as well as on harnessing the disciplinary role of market forces through better disclosure.
The ability of individual financial institutions and, by extension, of financial systems as a whole to withstand adverse shocks is directly linked to the existence of strong balance sheet buffers. Policymakers have recognised how important it is for capital and provisions to be commensurate with the risks in the asset portfolio of banks as well as with the risks in the overall economic environment where the banks operate. Basel II provides for a better alignment of regulatory capital requirements with the underlying risk and, by extension, also with the economic capital calculations of best practice banks. Its broad adoption will be a source of strength for the global financial system.
However, Basel II is not by itself the miracle cure of all financial sector ills. Its successful implementation depends critically on the existence of an adequate institutional infrastructure for the prudential framework as well as adherence to international standards of best practice by both the prudential authorities and the market practitioners. It also depends on the extent to which market forces are permitted to exert discipline on individual firms. Achieving better public reporting standards for both financial and non-financial firms is one way to improve the information available to investors and empower the disciplinary forces of the market. Improved financial reporting, greater disclosure regarding potential conflicts of interest and a solid auditing and enforcement framework can go a long way in boosting the confidence of all market participants in the integrity of the financial system. Similarly, clarity regarding prudential rules as well as consistency in their application helps to reduce the uncertainty for financial institutions and facilitate their business decisions. Clarity and consistency also avoid creating distortions in the playing field between local and foreign institutions, thus enabling the economy to maximise the benefits from competition.
Similar to the case of macroeconomic policy, the capital buffers applied to banks at the micro level, although extremely important, cannot be a substitute for sound management. As important as the capital cushion is the combination of best practices risk management (as part of the supervisory review under pillar 2) and market discipline through better disclosure.
And, as with foreign exchange reserves, the question of the optimal level arises also for prudential buffers. Could these buffers ever be too high? It could be argued that excessive capital levels would reduce the overall supply of bank credit in an economy. Moreover, for the buffers to function optimally as shock absorbers, they should ideally be accumulated in good times and run down in bad times in order to counter the influence of the business cycle on the behaviour of financial firms. These are valid questions which the calibration of Basel II has brought to the fore. International supervisors feel that today's level of regulatory capital is roughly balanced against the overall risks facing banks. The intention is for the new framework to maintain this balance while better aligning the distribution of capital in the system with underlying micro risks. Moreover, Basel II includes incentives for the substitution of better risk management practices for required capital, thereby recognising the key importance of internal discipline and rewarding banks' investment in best practice processes.
3. International cooperation
I have so far discussed the lessons that central banks have derived from dealing with the challenges of financial globalisation from the perspective of domestic policy responses. I would now like to turn to the international aspects of policy, in particular those related to the cooperation and coordination of authorities' efforts across countries. I will discuss cooperation as regards policy both at the micro, or institution-specific, level and at the macro, or economy-wide, level.
Before doing so, however, I want to highlight the importance of learning from each other. In this respect, the work of SEACEN is an excellent example of how the exchange of views and ideas on "what works and what doesn't" can be organised at the regional level. It is a stylised observation that countries that are closely situated geographically tend to also share features of their economies. Sharing experiences tends to accelerate progress by the group as a whole, speeding up the learning process and generating positive competition among peers.
At the micro level, internationalisation of financial services requires close cooperation among national authorities when it comes to the supervision of financial players that operate across borders. As some financial institutions' business models straddle several jurisdictions, the relationship between the home and host prudential authorities becomes a key factor in ensuring that risks are properly monitored and managed. This is so from the perspective both of the firm as a whole and of the individual economies in which it operates.
Ensuring the continuing influence of policy discipline on these cross-border financial institutions is not a new issue but it is one that attracts ever more attention. Authorities have adopted various ways of enhancing home/host cooperation and ensuring an appropriate bi-directional information flow. Memoranda of understanding, regular meetings, a college of supervisors and the designation of a lead supervisory agency are all good examples. These various arrangements are tailored to the particular characteristics of the activities of these institutions, the institutional structures in these countries and the requirements of the prudential authorities involved. Cooperation extends to considerations of the range of actions in the event that a financial firm with international operations should run into trouble and the buffers that could smooth the broader economic impact of these events. This could involve questions concerning potential availability of emergency liquidity assistance or an orderly winding-down of the firm's operations.
At a more macro level, cooperation in the context of financial services globalisation can take many forms. Some prominent examples are the adoption of common standards, as I mentioned earlier, the joint development of improved financial infrastructures, and the establishment of financial crisis management plans, including the creation of international buffer mechanisms.
I have already mentioned the importance of robust and efficient infrastructures for the promotion of market integration. The Asian Bond Fund (ABF) initiative marks an important step towards regional financial integration as a portion of foreign exchange reserves are invested in Asian sovereign bonds. It is a very good example of where coordinated regional efforts have given rise to improved financial infrastructures, and the BIS is honoured to have played a supporting role in this initiative. Through their participation in ABF 2, 11 central banks and monetary authorities in the Asian region have improved their understanding of specific impediments to the development of local bond markets and of ways to overcome them. In some countries, ABF 2 has already contributed to the liberalisation of capital controls, reform of withholding taxes and clarification of regulatory frameworks. Moreover, ABF 2 provides incentives to continue to reduce impediments. The weight of national markets in ABF 2 is linked to their openness. Therefore, as impediments to international integration are removed, the market's weight in the portfolio will rise.
Cooperation among prudential authorities, and central banks in particular, is equally important in the event that systemic stress manifests itself. It is often the case that systemic crises tend to spread across countries that have similar economic structures and close financial linkages. It is not easy to map out a crisis scenario in advance as each financial crisis is unique. However, having plans and contingencies to deal with emergencies creates the communication networks that are the foundation of an effective response in the event of an actual crisis.
The creation of safety buffers at the international level is an effective way of dealing with macro liquidity crises. The role of international financial institutions that can act as liquidity providers of last resort is well understood and their usefulness as a crisis management tool well tested. Global institutions, however, do not preclude the creation of regional bilateral and multilateral arrangements. These can play a complementary role, especially given the gap between the financial resources of global institutions and the size of the international financial markets. The Chiang-Mai initiative to create a network of bilateral swap arrangements is an example of what can be accomplished by regional cooperation. Almost USD 60 billion is now available through this Asian network.
In the field of international and regional cooperation, too, the benefits of building buffers against the potential materialisation of risks should not come at the expense of promoting discipline in behaviour. It is discipline that reduces the likelihood that crises will occur in the first place. Buffers in the form of international liquidity assistance can only be of temporary relief against a change in market sentiment. However, as all types of public insurance carry an element of moral hazard, international buffers too may prove counterproductive if they are perceived as sheltering imprudent decisions from their consequences. Crisis management tools cannot be a substitute for sound macroeconomic policies fostered by adequate surveillance at both regional and global levels.
In conclusion, it is clear that an internationalised financial sector puts a premium on a disciplined approach to policy. This includes the emphasis on policies with a focus on maximising the long-run benefits of a more open economic and financial system as well as efforts aimed at enhancing and "leveraging" the influence of market discipline on private and policy actions.
The dual challenge for central banks in the context of financial globalisation is not only to build the appropriate buffers to weather turbulences but more importantly to act as a "discipline multiplier" (ie to "leverage" the benefits of market discipline to support those of policy discipline).
The role of central banks is enhanced in this context by virtue of the fact that their policy mandate lies at the very centre of interactions between the financial and real sectors of the economy, between the microprudential and macroprudential aspects and between domestic and international financial systems. Moreover, central banks are already connected internationally through a number of overlapping networks that promote international cooperation.
Let me close by saying a final word on current BIS initiatives to deepen its involvement in Asia. Based on our historical vision for the BIS as a facilitator of central bank cooperation, these initiatives comprise a three-year policy-oriented research programme, an enhanced FSI contribution to financial sector supervision activity, and an extension of BIS banking services in the Asian time zones. We hope that these initiatives will strengthen the links between central banks in Asia and contribute to an enhanced capacity of central banks in the region to address the policy challenges posed by the greater internationalisation of financial services.
Thank you for your attention.