Prudential Regulation of Financial Markets in Developing Countries

Prudential Regulation of Financial Markets in Developing Countries

 

In a financial market, financial assets are traded: exchange of previously issued financial assets is enabled, and also, the facilitation of borrowing and lending of the sale of newly issued financial assets. (Mishkin, 2001; Tesfatsion, 2003) Examples of financial markets are: the New York Stock Exchange (resale of previously issued stock shares), the U.S. Government bond market (resale of previously issued bonds) and the U.S. Treasury bills auction (sales of newly issued treasury bills). (Mishkin, 2001; Tesfatsion, 2003)

Financial markets have six basic functions: borrowing and lending, because financial markets allow the transfer of funds, or the purchasing power, from one agent to another for investment or consumption purposes; price determination, because financial markets set prices for both the newly issued financial assets and the existing stock of financial assets; aggregation and coordination, because financial markets act as collectors and aggregators of information about financial assets values and the flow of funds from lenders to borrowers; risk sharing, because financial markets allow for a transfer of risk from those who undertake investments to those who provide funds for those investments; liquidity, because in financial markets, the holders of financial assets are provided the chance to resell or liquidate these assets; and finally, efficiency, because financial markets reduce transaction costs and information costs. (Mishkin, 2001; Tesfatsion, 2001)

In addition, financial markets have major players: brokers, or commissioned agents of a buyer or seller that facilitates trade by finding clients willing to engage in a desired transaction; dealers, who, like brokers, facilitate trade by matching buyers with sellers of assets-the differences between dealers and brokers, however, are that dealers can take positions in the assets he gets involve into, thus allowing him to sell out inventory, and that dealers do not receive commissions but rather make profits by buying assets at relatively low prices and reselling them at relatively high prices; and finally, the third major player in financial markets are investment banks, which assist in the initial sale of newly issued securities by engaging in a number of activities such as advising corporations, underwriting, and assisting in the sale of securities to the public. (Mishkin, 2001; Tesfatsion, 2003)

Further, financial markets have taken four basic structures: the auction markets, which is some form of a clearing house where buyers and sellers, together with their respective brokers, perform trade in open and competitive biddings. It is like a public market in the sense that it is open to all agents who wish to participate in trade; the over-the-counter (OTC) markets, which, unlike auction markets, have no centralized mechanism or facility for trading and instead, the market is a public market that is consisted of a number of dealers across a region, a country or even across the globe who “make the market” in some type of asset (the dealers themselves post bid and asked prices for this asset and then stand ready to buy or sell units of this asset with anyone who chooses to trade at these posted prices);  organized exchanges, a kind of financial markets that combine the features of auction such as the New York Stock Exchange, which combine auction and OTC market features and permits buyers and sellers to trade with each other in a centralized location, like an auction. However, securities are traded on the floor of the exchange with the help of specialist traders who combine broker and dealer functions; and finally, the intermediation financial market, a financial market wherein financial intermediaries help transfer funds from savers to borrowers through the issuance of certain types of financial assets to savers and receiving other types of financial assets from borrowers. (Mishkin, 2001; Tesfatsion, 2003)

            Finally, a problem that financial markets have to overcome is the asymmetric information. “Asymmetric information in a market for goods, services, or assets refers to differences (“asymmetries”) between the information available to buyers and the information available to sellers. For example, in markets for financial assets, asymmetric information may arise between lenders (buyers of financial assets) and borrowers (sellers of financial assets).” (Mishkin, 2001; Tesfatsion, 2003)

Moreover, there are certain types of problems that may arise due to asymmetric information: the adverse selection, or a problem that arises for a buyer of goods, services, or assets when the buyer has difficulty assessing the quality of these items in advance of purchase, and such a problem usually arises because of different information acquired between a buyer and a seller before the purchase deal takes place, and the problem of moral hazard, which may arise after an agreement between a buyer and seller of a good, service or asset have been signed, usually because the seller changes his behavior the seller changes his or her behavior in such a way that the probabilities used by the buyer to determine the terms of the purchase agreement are no longer accurate, and the buyer was not able to observe this change in the seller’s behavior. (Mishkin, 2001; Tesfatsion, 2001)

            In addition, the key instruments of financial markets include: equities or shares (known as “stocks” in the United States); mutual funds, also known as an investment company, a corporation that gathers investor’s money basically to buy sticks and bonds; bonds,  or medium to long-term negotiable debt securities issued by governments, government agencies, federal bodies (states), supra-national organizations (like the World Bank) and companies; OTC money market products that are based upon borrowing or lending, such as loans and deposits, which are neither negotiable nor securitized; spot foreign exchange, or the buying and selling of foreign currency at the existing exchange rates; and finally, commodities, which include grain, coffee beans, etc. (Giddy, 2003)

            In relation, financial industries have always been regulated so as not to lose public confidence; usually, the case of regulation is based upon the existence of various types of market failure, notably the existence of asymmetric information, while strong arguments against regulation are centered on the ideas of moral hazard, agency capture and compliance costs. (Bain, 1996) However, regulation may also contribute negatively to financial markets, since regulation increases the costs of entry and exit for new firms, thus inhibiting competition, and in some circumstances, regulation may even increase the instability of an industry. (Bain, 1996)  One form of regulation essential in financial markets is prudential regulation. The intention of prudential regulation is to channel capital inflows through institutions that are most likely to make sound investment decisions. (Garber, 1996) Moreover, prudential regulation in financial markets basically intends to contribute in providing secure and reliable practices in financial services, and to contribute to financial and economic stability. (Monetary Bulletin, 2002) In addition, regulations all over the globe have to deal with multiple issues and challenges so as to ensure that regulations are not too “rules-based” and that their design does not encourage potential moral hazard or unsound industry practices. (Akhtar, 2000) Further, a good prudential regulatory and supervisory framework intends to: protect consumers through the promotion of an orderly and safe system with emphasis on the soundness of insurance and pensions industry; rear transparency, competition and “competitive neutrality”, where rules are applied equally to all firms; offer incentives to owners, managers and industries so as to adopt good corporate governance and thus monitor, control and self-regulate themselves and also, for their clients to exercise due diligence. (Akhtar, 2000) With regard to consumer protection, it is important to distinguish the difference between prudential regulation and systemic regulation. (Akhtar, 2000) Accordingly, prudential regulation is about the safety and soundness of financial institutions in relation to consumer protection, because in this case, a consumer loses when an institution fails; a systemic regulation, on the other hand, is concerned about the safety and soundness of financial institution for systemic reasons, because the social costs of a failure of an institution exceed the private cost. (Akhtar, 2000) Moreover, Akhtar (2000) said prudential regulatory and supervisory framework will not be effective if: there are no proper “rules of conduct of business regulation” to encourage information disclosure, honesty and integrity of firms, their employees, agents and brokers, fair business practices, competency and accountability; there is feeble enforcement that fails to enforce sanctions for noncompliance or punish defaulters; the system permits regulatory leniency because of political pressures; the legal framework does not support enforcement of contracts; the accounting and actuarial professional standards are not uniform or are weak and unreliable; and asymmetric information in the market still prevails. Accordingly, the scale, nature and costs of the regulatory framework and issue in relation to the state of prudential regulatory and supervisory framework differ all over the world and depend a lot on the characteristic of the industry in a country. (Akhtar, 2000) In addition, globalization and financial innovation influence financial markets to a great extent, and these two financial influences caused particular problems for regulators. (Bain, 1996) Because of globalization, the need for coordination of activities among bank supervisors and the need for the development of common regulatory standards so as to avoid competitive carelessness among supervising authorities are some of the problems that emerged. (Bain, 1996) The following countries have been cited as examples: In the Philippines, the Bangko Sentral ng Pilipinas (BSP), the country’s monetary authority, sees to it that monetary policy is supportive of its mandate of maintaining price stability favorable to sustaining economic growth. (Buenaventura, 2001) Accordingly, with long-term savings and investments are encouraged through price stability, which in turn leads to the growth and development of the financial market of the country. (Buenaventura, 2001) In addition, the BSP promotes the stability and soundness of the financial system, being the regulator of the financial system; stability and soundness of the financial system, accordingly, is the key to overall economic stability and growth. (Buenaventura, 2001) Therefore, in order to help the Philippine financial market move forward under a globalized environment, it is important for the BSP to set the right environment through reforms and policy directions. (Buenaventura, 2001) To set the environment conducive in moving forward under a globalized environment, the BSP shifted to inflation targeting as the monetary policy framework in 2001. Buenaventura (2001) explained: “Under the inflation targeting framework, the BSP will announce explicit inflation targets to the public.  Inflation targeting thus provides a clearer assignment of the BSP’s accountability to the objective of promoting price stability and increases the transparency of monetary policy.” In addition, this shift is significant, as the growing body of evidence shows that low inflation helps, in the long run, in the promotion of growth and efficient resource allocation; also, controlling inflation, accordingly, will help the Philippine financial market avoid asset price bubbles, achieve lower interest rates in the long term, stabilize the exchange rate, and thus, help maintain the soundness of the said country’s financial system and overall macroeconomic stability. (Buenaventura, 2001) On the other hand, the BSP also adopted major reforms in financial regulation and legislation to address the concerns raised by globalization on the stability of the financial system. (Buenaventura, 2001) Buenaventura (2001) explained: “The growth in the size and complexity of financial markets has brought about considerable benefits in terms of a broader menu of alternative sources of funds for investment and a shorter process of technological acquisition.”

Moreover, for the Philippine government adopted a multi-pronged approach so as to help meet the challenges of globalization, while the BSP, in relation to the case of banking system (making banks internationally competitive), prudential measures were strengthened, mergers and consolidations were encouraged, and the legislative and regulatory framework, wherein the main legislative framework is provided by the General Banking Law of 2000 (R.A. No. 8971, or GBL 2000), was improved. (Buenaventura, 2001) Significant attributes of the GBL 2000 include: granting authority to the Monetary Board to require banks to adopt internationally accepted standards relating to risk-based capital adequacy; providing for stricter rules governing bank exposure to directors, officers, stockholders and related interests; further liberalizing the ownership participation of foreign banks in the local banking system to 100 percent within seven years after the implementation of the GBL 2000; and granting authority to the BSP to regulate electronic banking. 

In addition, to strengthen prudential regulations, informative framework for risk management standards useful for banks in understanding risks and shaping their own risk management infrastructures have been advanced by the BSP and the Bankers Association of the Philippines (BAP). Also, the BSP developed a foreign exchange manual, which institutionalizes a system of financial records, operational procedures and control mechanisms applicable to all operating units in a bank to account for foreign exchange transactions and allows banks to monitor it total currency exposure at any given time. (Buenaventura, 2001) Further, the existing payment system is being developed into a Real Time Gross Settlement (RTGS) system so as to improve operational efficiency, reliability, speed and timeliness of payment transactions in the face of rapidly increasing volume and value of transactions; the RTGS will provide a powerful mechanism that will limit settlement and systemic risks in the inter-bank process, thus, stability of the whole financial system will be ensured. (Buenaventura, 2001)

In Malaysia, historical landmarks that are critical in the achievement of their endeavor to build a strong and sound Islamic financial system include the establishment of the Islamic Development Bank in 1975, the establishment of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in 1990, and the recent establishment of the Islamic Financial Services Board in 2002. (Aziz, 2002) Aziz (2002) said that through the inauguration of the Islamic Financial Services Board, Malaysia is laying the foundation for the promotion of a sound and stable Islamic financial system that will pave the way for its successful integration as a viable and credible component of the global financial system. (p.1)

He further discussed in the inauguration of the Islamic Financial Services Board in November 3, 2002: “Islamic banking and finance in Malaysia is ascending to greater prominence in the global financial system and has fast extended beyond the traditional predominantly Muslim economies to major industrial economies. This growing significance is a manifestation of the viability if Islamic banking as a financial intermediation channel that supports economic growth and development of nations. While it was initially developed to fulfill the needs of the Muslims, Islamic banking and finance has now gained universal acceptance. The appreciation of its promising potential has prompted interest amongst conventional financial institutions to venture into this fast expanding market. In essence, Islamic banking and finance can expect to evolve into an increasingly important component of the global financial system.” (p. 1)

However, the need for the development of the regulatory dimension to explicitly address the unique features of Islamic banking and finance also emerged with this expansion. (Aziz, 2002) Therefore, the development of a separate regulatory framework was needed to provide for the effective assessment and management of the unique risks in Islamic financial transactions; accordingly, a prudential regulatory design such as that would further complement concurrent efforts that are underway to develop Islamic financial markets and Islamic financial instruments. (Aziz, 2002, p. 1)

Consequently, the Islamic Financial Services Board (IFSB), accordingly, will serve as an association of central banks, monetary authorities and other institutions that are assigned to develop and to spread internationally accepted prudential regulatory standards and best practices; thus, the IFSB will act as a go-between and will work together with other international standard setting bodies to achieve the common goals of international financial stability. (Aziz, 2002) In addition, the IFSB will focus on the development of risk management instruments, cultivation of sound risk management practices and facilitate the implementation of strong risk control mechanisms in Islamic institutions through research, training and technical assistance, thus covering the adoption of international best practices on risk management standards as well as the development of new risk management techniques in accordance with Shari’ah injunctions. (Aziz, 2002, p. 2)

In relation, Malaysia has recognized that the forces of globalization, financial liberalization, technological advancements, intensified competition and financial innovation have created new risks that are more complex and have deeper systemic implications; to manage these risks, prudential regulation and supervisory insight have become more demanding and challenging. (Aziz, 2002) Thus, to be more risk-focused and risk-sensitive, and also, to ensure international financial regulators and supervisors will be able to respond effectively to the changing environment, the Basel Committee has revised its Capital Accord. (Aziz, 2002)

Moreover, Aziz (2002) discussed that a more flexible capital framework that promotes an enhanced degree of capital sensitivity to actual risk complexities is appropriate for the governance of an Islamic financial institution; thus, a diverse spectrum of Islamic financing structures varying from low risk sales and lease-based modes of finance to the higher risk-equity-based modes will exemplify an Islamic financial institution’s asset profile. (p. 2) Aziz (2002) further said: “Each of these modes of finance has a distinct intrinsic characteristic dictated by its underlying Shari’ah principles and thus, entails different risk profiles.” (p. 2)

Aziz (2002) concluded: “It has been said that Islamic banking and finance is a ‘mirror of the sea’ for until and unless we have the courage to explore its depth, we would never be able to uncover the treasures that reside within. Islamic banking as a new sphere of finance promises vast opportunities and benefits for all. Its integration into the global financial system will contribute towards achieving our shared aspirations for financial stability to ensure balance growth in the global economy”. (p. 3)

Let us now look into a research study conducted in relation to the 1997 Thailand crisis. Hartmann-Wendels and Menkhoff (2000) basically intended to find out if tighter prudential regulation could have prevented the financial disaster that happened in Thailand in 1997, or could it be that the macroeconomic shocks that hit Thailand’s banks were so great that even tighter regulations could not have saved the financial institutions.

Hartmann-Wendels and Menkhoff (2000) said that most analyses have shown that the obvious reasons for economic crises are the weaknesses and fragilities of financial sectors, therefore, financial institutions in countries experiencing crisis have severe shortcomings. Just as in the case in Thailand. Accordingly, three areas of concern surfaced: first, the internal evaluation mechanism for loan extensions was inefficient, if not nonexistent; second, the management of risky portfolios displayed a severe lack of experience; and third, prudential regulation was often lacking or not enforced. (Hartmann-Wendels and Menkhoff, 2000) Hartmann and Menkhoff further said: “These three aspects led in combination to a dark scenario as the institutions neither had the experience to address credit and market risks appropriately, nor did they feel strong incentives to improve. To cure the central problem of financial sector weakness it seems to be an obvious solution to implement established prudential standards.” (p. 2)

Hartmann-Wendels and Menkhoff (2000) concluded that: tighter prudential regulation would have been useful for Thailand’s banks as it helps to cool the bubble, although unfortunately only a little bit, and as it makes financial institutions much more robust in the case of an economic crisis; the tightness of regulation can become relevant on a level below a superficial application of the Basel Accord, an aspect of particular relevance in developing economies. The formal application should be complemented by appropriate standards and by strict and transparent accounting practices; and, the present regulatory framework has two major limitations important for the Thai case: exchange rate risk passed on to customers can backfire in the form of later credit risk and maturity mismatch can be dangerous in connection with volatile capital flows and an open capital account. (pp. 35-36)

Further, Hartmann-Wendels and Menkhoff (2000) said: “Prudential regulation is not designed to save banks in case of a dramatic macroeconomic crisis. Thus, prudential macroeconomic policy is a necessary precondition for financial institutions to flourish in the long run, which should complement the microeconomic reforms highlighted in the present discussion.” (Hartmann-Wendels and Menkhoff, 2000, p. 36)

Finally, the let us now look on the impact of the Asian financial crisis on Vietnam’s financial and banking system. The research conducted by Doan (2001) analyzed the causes of the crisis, the situation in Vietnam after the crisis, and the implications of the crisis for future financial development and banking reforms. In the study, three main areas of impact were identified: the devaluation of the Dong, impact on the banking sector, and the pressure on the balance of payments; also, government policy responses were outlined.

The research found out that: the financial system in Vietnam is under-developed and dominated by the banking sector; capital and money markets in Vietnam are very under developed; the banking sector shares the same weaknesses of its counterparts in Asia such as a high ratio of non-performing loans, resulting from bad lending practices, inflexible exchange rate management, and weak prudential regulation and supervision; and, Vietnam’s financial system is characterized by slow institution building, and severe governance problems. (Doan, 2001)

Further, in order for Vietnam to have a healthy banking system, one with adequate and effective prudential regulation and supervision, there is a need to: strengthen the domestic financial system, accompanied by institution building and establishment of a legal framework to ensure transparency, disclosure, and cover bankruptcy and collateral lending; restore public confidence in the banking system; restructure the banking system; reform the governance structure for effective supervision and regulation; and develop financial markets that will complement its banking system.(Doan, 2001)

 

 

References:

 

Akhtar, Shamshad. (2000). Perspectives and Issues in Prudential          Regulation and Supervision and its Enforcement. In Asian     Development Bank. Available at: [http://www.apec-            finsecreg.org/documents/PreRead_02_Ahktarpaper_000.doc].   Accessed: [28/01/04].

 

Aziz, Zeti Akhtar. (2002). Islamic Banking and Finance. In BIS Review,   64/2002, pp. 1-3.

 

Bain, Keith. (1996). The Regulation of Financial Markets. In Department of        Economics, University of East London. Dagenham, Essex: University of       East London.

 

Buenaventura, Rafael B. (2001). Moving the financial Markets Forward.  In      Bangko Sentral ng Pilipinas. Available at:        [http://www.bsp.gov.ph/archive/Speeches_2000/MovingFinancial.htm             Accessed: [28/01/04].

 

Doan, L. (2001). The Asian Financial Crisis and its Implications on the Financial System of Vietnam. In Eldis. Available at:          [http://www.eldis.org/static/DOC9880.htm]. Accessed: [28/01/04].

 

Mishkin, Frederick S. (2001). The Economics of Money, Banking, and Financial Markets. Boston, MA: Addison-Wesley.

Garber, Peter. (1996). Managing Risks to Financial Markets from Volatile         Capital Flows: The Role of Prudential Regulation. In International            Journal of Finance & Economics, Volume 1Number 3, pp. 183-95.

Giddy, Ian. (2003). Markets & Instruments: Highlights-The Financial Markets.        New    York: New York University (NYU) Leonard N. Stern School of            Business.

 

Hartmann-Wendels, Thomas and Menkhoff, Lukas. (2000). In ZEF –      Discussion Papers on Development Policy No. 28, Center for Development Research, Bonn, July 2000.

 

___. (2002). Prudential regulation on liquidity ratio and foreign exchange. In   Monetary Bulletin, Volume 3, Number 41.

 

Tesfatsion, Leigh. (2003). Introduction to Financial Markets. In Econ 308x        Web Site. Available at:             [http://www.econ.iastate.edu/classes/econ308/tesfatsion/finintro.htm.              Accessed: [28/01/04].

 

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