Documente Academic
Documente Profesional
Documente Cultură
AUSTRALIA 29
O RIGINS OF FINANCIAL DEREGULATION 29
D EVELOPMENTS AFTER DEREGULATION 31
iii
CONTENTS
T HE POLICY RESPONSE 33
B ENEFITS OF REFORMS 38
D ESIGN OF FINANCIAL REGULATION FRAMEWORK 41
B ROADER POLICY LESSONS 43
G OING FORWARD 44
C ANADA 47
T HE FINANCIAL SERVICES SECTOR 47
K EY FACTORS DRIVING CHANGE 47
C HALLENGES FACING THE INDUSTRY AND REGULATORS 50
F INANCIAL INSTITUTION POLICY 52
D EVELOPMENTS IN PAYMENT SYSTEMS 56
E NCOURAGING FINANCIAL MARKETS : A CASE STUDY 59
C HINA 64
P OLICY MEASURES TO PROMOTE INSTITUTIONAL BUILDING 64
MAJOR ISSUES OF INSTITUTION BUILDING IN THE FINANCIAL SECTOR 66
R OLE OF THE GOVERNMENT 67
R OLE OF THE CENTRAL BANK 68
R OLE OF THE INTERNATIONAL FINANCIAL INSTITUTIONS 69
T HE ROLE OF FOREIGN BANKS 69
T HE ROLE OF NEW TECHNOLO GY 70
I NSTITUTION BUILDING FOR THE C HINESE B OND MARKET 70
I MPACT OF FINANCIAL SECTOR DEVELOPMENTS ON
ECONOMIC GROWTH 73
O UTLOOK FOR INSTITUTIONAL REFORMS IN THE COMING YEARS 75
F RANCE 80
T HE FIRST STEPS TOWARD LIBERALIZATION BEFORE 1984 80
T HE B ANKING A CT OF 1984 GAVE THE REAL IMPETUS TO
F RENCH BANKING LIBERALIZATION 81
T HE B ANKING A CT PAVED THE WAY FOR A STRONGER
BANKING SYSTEM 83
iv
CONTENTS
G ERMANY 91
G ERMANY ’ S MACROECONOMIC AND LEGAL FRAMEWORK 93
P RINCIPLES OF BANKING SUPERVISION 97
N EW MEASURES FOR SAFEGUARDING CLIENTS OF LIFE INSURERS 104
C APITAL MARKET REFORMS IN THE WAKE OF GLOBALIZATION 105
I NDIA 122
P OST - INDEPENDENCE INSTITUTION BUILDING 122
T HE REFORM YEARS : 1991–2004 128
I MPACT OF FINANCIAL INSTITUTION BUILDING 135
S CHEDULED COMMERCIAL BANKS 136
T HE FUTURE OF I NDIA’ S FINANCIAL SYSTEM 142
L ESSONS FROM I NDIA’ S EXPERIENCE 144
C ONCLUSION 146
v
CONTENTS
I ND ONESIA 148
B ANKING REFORM 148
N ONBANK FINANCIAL INSTITUTION REFORM 152
F URTHER INSTITUTIONAL CHANGES FOR THE BANKS 157
F URTHER INSTITUTIONAL CHANGES FOR NONBANK
I TALY 165
M AIN CHANGES IN THE I TALIAN FINANCIAL SYSTEM DURING
J APAN 193
D EVELOPMENT OF THE FINANCIAL SYSTEM IN THE HIGH -
GROWTH PERIOD 193
T HE END OF HIGH GROWTH AND THE BEGINNING OF A
TRANSFORMATION IN THE FINANCIAL SYSTEM 195
P ROVISIONAL APPRAISAL 198
M EXICO 229
P ROTECTED FINANCIAL MARKETS ( FIRST PHASE : 1970–88) 229
F ORTIFYING FINANCIAL INSTITUTIONS ( SECOND PHASE :
1988–94) 230
vi
CONTENTS
vii
CONTENTS
viii
CONTENTS
ix
P REFACE
The international debt crises of the past decade revealed major policy short-
comings in a number of emerging market economies. While clear progress had
been made in strengthening macroeconomic policies, important weaknesses
persisted in the financial sector of these countries. In this situation, growth
strategies based on speedy deregulation and liberalization of financial markets
often failed. In many cases, the impact of balance of payment problems on the
real economy was exacerbated by concomitant banking sector crises.
International efforts to strengthen crisis prevention therefore started to focus
more than before on building strong financial sectors. In addition to enhanc-
ing banking sector resilience, these endeavors should increase the depth of
domestic financial markets and reduce the need to borrow in foreign curren-
cies for financing domestic activities. Deep domestic financial markets should
help to contain the emergence of currency mismatches, a common element
in recent international financial crises.
At their annual meeting in November 2002 in New Delhi, G20 finance
ministers and central bank governors emphasized the relevance of institu-
tions for economic development. Institutions have been perceived as the for-
mal or informal “rules of the game” that shape the behavior of authorities and
market participants. Since the G20 brings together the major industrial and
emerging market economies of the world, ministers and governors deemed
it to be an excellent forum for exchanging experiences on institution build-
ing in the financial sector. These efforts focused, in particular, on the rules
governing macroeconomic policies and financial sector supervision, as well
as on the institutional setting for payment systems and on the legal frame-
work.
This book takes stock of this G20 initiative on Institution Building in the
Financial Sector, which began under the stewardship of the Mexican chair in
2003 and continued in 2004 under the German presidency. It mainly contains
short updated versions of case studies and cross-country reviews prepared by
a broad range of G20 members on their experience with the establishment of
institutional frameworks for the financial sector. The book also includes a
condensed summary of a workshop with academics and private sector repre-
sentatives on Developing Strong Domestic Financial Markets, co-sponsored by
the Bank of Canada and the Deutsche Bundesbank in April 2004 in Ottawa.
Two further reports to ministers and governors present the most important
subjects addressed in the case studies and cross-country reviews and, building
x
PREFACE
on this, reflect the main conclusions of the G20 deputies’ inquiry into the pri-
orities of institution building in the financial sector.
We would like to thank all G20 members for their invaluable contribu-
tions to this project, and in particular our G20 deputies Javier Guzmán,
Director of International Affairs at Banco de México, and Juergen Stark, Vice
President of the Deutsche Bundesbank, who initiated and managed this pub-
lication. We are also grateful to the World Bank, which helped to edit all the
material presented and shared part of the editing costs.
xi
I NSTITUTION BUILDING IN THE
FINANCIAL SECTOR
OVERVIEW OF G20 DISCUSSIONS
Although the link between appropriate institutions and economic perfor-
mance has been studied for many years, it is an issue that has gained much
more prominence lately. This is unsurprising, given the number of recent
empirical studies supporting the view that differences in the quality of insti-
tutions explain a significant part of income discrepancies across countries.
Some economists have concluded that the quality of institutions is more
important as a determinant of long-term economic performance than, say,
geographical location or trade integration.
In this context G20 finance ministers and central bank governors decided
to include in the Group’s agenda for discussion an in-depth assessment of the
impact of institution building on economic performance. The objective was
to benefit from the different stages of economic development and from the
diversity of experiences among the Group’s members, with a view to con-
tribute to a better understanding of this important issue. Given the compar-
ative advantages of the G20, it was natural to focus attention on the particular
case of the financial sector. In this regard, G20 members stressed that strong
financial sectors provide a source for long-term financing in local currency and
discourage currency mismatches, helping to protect economies from external
shocks. Strong financial sectors also foster domestic savings and improve the
allocation of financial resources.
What are the main conclusions? At a general level, the most important
messages that emerge from the work undertaken are:
• Building the appropriate institutional framework is a cumulative effort
that takes a long time and that must be adapted to changing circum-
stances. Policymakers should not neglect building high-quality insti-
tutions, since they are indispensable for rapid and sustained growth.
• Institution building and globalization have a two-way relationship. On
the one hand, while a deeper integration into the world economy
The objective of this section is to summarize the central messages emerging from
G20 discussions on Institution Building in the Financial Sector. The views expressed
here are the sole responsibility of the authors and should not be considered as the
official position of the G20.
xii
DEUTSCHE BUNDESBANK AND BANCO DE MÉXICO
xiii
OVERVIEW OF G20 DISCUSSIONS
xiv
DEUTSCHE BUNDESBANK AND BANCO DE MÉXICO
xv
PART I
R EPORTS TO
F INANCE M INISTERS AND
C ENTRAL B ANK G OVERNORS
R EPORT TO
F INANCE M INISTERS AND
C ENTRAL B ANK G OVERNORS
P REPARED BY B ANCO DE M ÉXICO
M ORELIA , M EXICO , 26–27 O CTOBER 2003
3
REPORT TO FINANCE MINISTERS AND CENTRAL BANK GOVERNORS
and the United States. In addition, the European Central Bank, the Inter-
national Monetary Fund (IMF) and the World Bank prepared studies dealing
with these issues from a cross-country perspective.
This report briefly discusses the main subjects addressed in these studies. The
exercise is complex because the issues and the emphases varied substantially by
study. In fact, one of the main purposes of this report is to try to highlight the
most important issues raised, with the objective of conducting an in-depth con-
sideration of very specific topics that could be discussed by the G20 later on.
Several studies emphasize that the unique experience of individual G20
members with institution building in the financial sector cannot serve as a blue-
print or detailed roadmap for the optimal pace and sequencing of institutional
development in other countries. The institutional framework must be closely
geared to country-specific circumstances. But the consideration of other coun-
tries’ experiences with institution building can offer important lessons for
economies seeking to construct an efficient and effective framework for the
financial sector.
The studies prepared for this project cover a wide range of topics. For
purposes of efficiency, this report concentrates only on those drawing the
highest attention and those giving rise to more debate and useful lessons. In
this context, the following subjects are considered:
• Benefits and challenges of financial deregulation and liberalization.
• Whether financial deregulation and liberalization have strengthened
institution building.
• Central components of an adequate institutional framework for the
financial sector.
• The role of international financial institutions.
4
MORELIA
coupled with low real interest rates for bank deposits, sometimes caused a con-
siderable expansion of informal credit markets, which increased the potential
for instability and complicated the implementation of monetary policy.
More generally, financial deregulation and liberalization were seen as a
means to enhance the development of the financial system through several
channels. Although it is difficult to isolate their effects from those of other poli-
cies implemented concomitantly, overall the studies that analyze the impact
of financial deregulation and liberalization report a positive influence on the
development of the financial system. First, the increase in the breadth and
depth of financial markets should reduce transaction costs. Second, by
expanding the pool of liquidity in markets, financial liberalization should pro-
vide greater scope for diversification and permit more efficient pricing of risk.
Third, financial deregulation and liberalization were also seen as a means to
improve the allocation of financial savings, by removing barriers to the flow
of savings into the highest yielding investments, by reducing interest rate mar-
gins with more competition and by fostering greater financial innovation to
meet the needs of consumers of financial services.
The increased competition brought about by liberalization and deregula-
tion was seen as crucial in some cases. According to these views, in the long run
there cannot be efficiency without competition, and without efficiency there
cannot be stability in the banking and financial industry. Furthermore, the
larger presence of foreign banks that resulted from financial liberalization con-
tributed to the strengthening of the banking sector’s capital base, improved the
efficiency of the financial system through the implementation of better tech-
nology and risk management practices and had a demonstration effect on the
rest of the financial system. In the case of the European Union, financial inte-
gration is helping build efficient institutions and has had a measurable impact
on the region’s GDP growth.
Notwithstanding the positive impact of financial deregulation and liberal-
ization on the development of the financial sector, some caveats have to be
made. First, the positive influence of regulation under certain economic and
social conditions is underlined in one case study. Second, several studies warn
of the risks that might accompany efforts of this nature. In some cases, inno-
vation in product design blurred the boundaries between financial instruments
and institutions, thus giving rise to regulatory gaps. Also, in a deregulated envi-
ronment, banks were able to lend to higher-risk borrowers and also needed to
take account of exchange and interest rate risks to a greater degree than before.
As banks were sometimes slow to adjust risk assessment procedures in the new
5
REPORT TO FINANCE MINISTERS AND CENTRAL BANK GOVERNORS
6
MORELIA
7
REPORT TO FINANCE MINISTERS AND CENTRAL BANK GOVERNORS
8
MORELIA
9
REPORT TO FINANCE MINISTERS AND CENTRAL BANK GOVERNORS
institution with limited guarantee coverage was established once the crisis was
overcome, or this is an objective of the authorities for the long term.
10
MORELIA
advanced ones, see substantial room for development of the corporate debt
market. Furthermore, collateralized securities issued by banks are referred to
as instruments that improve the term structure of the bond market.
Several studies point to the necessity of strengthening the equity market
as an important part of the domestic capital market to meet the financing
requirements of the economy. Streamlining the regulatory framework,
enhancing market transparency and the protection of investors, increasing
access to foreign capital and reducing operational costs are among the poli-
cies deemed as important to strengthen domestic equity markets.
Payment systems
The case studies identify the revamping of the operational and regulatory
framework of payment systems as an important part of the institutional devel-
opment of the financial sector. Several case studies refer to the responsibility
of the central bank in promoting stability and efficiency in the payment sys-
tem. Furthermore, some highlight that institutional developments in payment
systems have been market-led rather than driven by legislative or policy change.
Globalization and integration of markets and the concurrent growth in
private capital flows have led country authorities to review their payment sys-
tems. The aim has been to enhance the operational efficiency, reliability, speed
and timeliness of payment transactions while reducing or containing finan-
cial and (most notably) systemic risks. In addition, there has been a desire to
ensure that the speed and reliability of payment systems keep pace with the
effective demand for payment services by financial market participants. Rapid
progress toward indirect monetary policy, financial deregulation and liberal-
ization and currency convertibility have often been behind concomitant
reforms in payment system policies and operations.
The information in standards assessments carried out by international
institutions in the area of payment systems point to a high degree of obser-
vance in advanced economies. In developing countries, however, many pay-
ment systems have design and operational limitations that expose them to
more important risks and that often also imply efficiency shortcomings.
Legal framework
Legal certainty is an important precondition for the proper functioning of a
market economy. It requires legal concepts and instruments that are closely
geared to the practical needs of economic agents and effective procedures for
enforcement.
11
REPORT TO FINANCE MINISTERS AND CENTRAL BANK GOVERNORS
Although the case studies refer to many elements of the legal framework
for the financial sector, the role of reliable collateral and insolvency legisla-
tion is identified in some studies as a key requirement for market efficiency
in this sector. A standard method of containing credit risk (and thereby
reducing the cost of capital) is the demand for collateral from the borrower.
Providing collateral is generally even a condition for gaining access to long-
term bank borrowing. No collateral framework is, however, of any use with-
out efficient enforcement rules in the event of insolvency. The importance of
appropriate bankruptcy and secured lending legislation is underlined by the
experience of one country, in which the absence of an appropriate legal
framework in this regard has been deemed a major obstacle for the resump-
tion of bank lending to the private sector several years after having experi-
enced a banking crisis. The role of bankruptcy legislation in establishing a
market-based system for the closure of nonviable financial institutions is also
noted in some studies.
Technology
Several studies point to the fact that operating in a globalized environment
requires a high level of technological development. Thus, information and
communication technology is fundamental for strengthening institution
building in the financial sector. In one of the case studies, the failure to adapt
to the revolutionary progress observed in information and communication
technology was deemed a major cause of the emergence of an economic cri-
sis. Among the considerations for adopting new technology, the studies
include the following: that new technology operates reliably and is fully devel-
oped and tested, that it permits future enhancement to a level consistent with
the most up to date procedures and that it is compatible with prevailing prac-
tices. Technological developments are not free of risk. For instance, some stud-
ies stress that the swift development of online financial services poses
important challenges for monetary policy and financial supervision. Thus,
regulators must keep adequate track of technological developments and their
implications for financial supervision and the implementation of monetary
policy.
12
MORELIA
(FSAP), is outlined in several studies. Overall, the work carried out under
FSAPs was considered to be of high quality and to provide an objective and
rigorous evaluation of financial systems. Standards assessments completed in
the context of an FSAP have been most useful in identifying gaps and defin-
ing the priorities of institutional reform. By setting the diagnosis in a broader
macroprudential context, the assessments also helped authorities sequence
institutional reform. Discussions in the FSAP context allowed the authorities
a useful exchange of views, and self-assessments performed as background
for the FSAP compelled them to review the strengths and weaknesses of the
financial system and its institutions on the basis of an international point of
reference. In many instances, an FSAP provided an impetus to the authorities’
reform efforts and helped sharpen or redirect the focus of reform.
Some studies note that FSAPs are not free of problems, though. First,
standards and codes assessments carried out as part of an FSAP may not be
consistent with a country’s stage of development. Thus, country involvement
in the design and implementation of standards and codes remains crucial. In
addition to ensuring that standards and codes are implemented taking into
consideration local practices and infrastructure, this may allow the authori-
ties to make an adequate diagnosis of the problems faced in one particular
sector before an FSAP is carried out. Second, to be useful in the medium and
long term, FSAPs need to be updated frequently. But capacity constraints
make this unlikely. Third, implementing the recommendations from FSAPs
often requires appropriate technical assistance, but the resources available
for this purpose are scarce. Fourth, especially since reports are infrequently
updated and in some cases not even published, markets are not yet taking
fully into consideration the evaluations made by the IMF and the World Bank
under FSAPs.
13
REPORT TO FINANCE MINISTERS AND CENTRAL BANK GOVERNORS
early stage. Moreover, institution building in the financial sector is not a sin-
gular event, but an ongoing process that must be constantly adapted to keep
pace with market developments.
Financial deregulation and liberalization can be a major stimulus for the
development of appropriate institutions. The challenges raised by financial
deregulation and liberalization sometimes give rise to a new wave of reforms
aimed at overcoming institutional deficiencies. Other times, deregulation
results in additional market scrutiny that stimulates institution building. The
experience of the European Union shows how defining a set of harmonized
minimum requirements applicable to all members can stimulate institution
building, especially in relatively less developed economies.
Central bank independence, the development of mechanisms aimed at
fostering sound public finances on a long-term basis and appropriate schemes
for the coordination of the authorities overseeing monetary, fiscal and super-
visory functions are fundamental for an adequate institutional setting for the
financial sector.
The evidence available in the case studies does not provide a definitive
conclusion on the appropriate institutional framework for supervision of
financial institutions and markets. Nevertheless, several issues are highlighted
that deserve further consideration, including: the merits of granting broad
supervisory powers to the central bank compared with separating the opera-
tion of monetary policy and banking supervision, the creation of a single
agency in charge of financial supervision, the importance of an independent
supervisory authority and the need to update regulations to keep pace with
financial market developments and to strengthen cross-border cooperation in
the areas of prudential supervision, financial stability and crisis management.
It is also important to acknowledge the importance of the incentive structure
provided by the mandate, accountability and governance arrangements of the
supervisory and deposit insurance agencies.
A common feature of the studies is the concern of deposit insurance’s impact
on moral hazard. The importance of avoiding comprehensive government guar-
antees for deposits and encouraging banks to handle crises with their own means
are stressed. Nevertheless a general loss of confidence in a banking system with
limited deposit insurance may in fact increase the risk of market panic.
Payment systems are a central part of the institutional framework of the
financial sector. The development of payment systems is driven by a combi-
nation of forces, including involvement of the central bank, market stimulus,
the desire to contain risk, the adoption of indirect instruments for monetary
14
MORELIA
policy and so on. The evidence collected through standards and codes assess-
ments shows that payment systems in many developing countries have vari-
ous design and operational limitations that expose them to serious risks.
Legal certainty is an important precondition for a properly functioning
market economy. Several studies refer in particular to the role of reliable col-
lateral and insolvency legislation for enhancing financial sector efficiency. The
experience of the European Union, where this legislation has been built with
a view to contributing to the integration and cost-efficiency of financial mar-
kets, as well as to the stability of the financial system, may be particularly use-
ful in this regard.
Operating in a globalized environment requires a high level of techno-
logical development. Thus, appropriate information and communication
technologies are fundamental elements in strengthening institution building
in the financial sector.
Economic development is stimulated by viable domestic capital markets
that enable private and public borrowers to obtain loans in local currency
with longer-term maturities. Thus, the creation of the institutional infra-
structure needed for the development or strengthening of domestic debt mar-
kets has central importance. In this context, special consideration should be
given to the factors contributing to the expansion of the corporate debt mar-
ket. Moreover, a strong equity market has an important role in improving the
efficient allocation of resources and lowering the dependence on foreign cur-
rency borrowing.
The IMF and World Bank work on FSAPs has yielded useful results. G20
members are encouraged to undergo FSAPs, not only because of the benefits
that accrue to each individually, but also because of the positive effects for
global financial stability. On the other hand, every effort must be made to
ensure that sufficient resources will be available to meet both the demand for
FSAPs and the accompanying technical assistance needs, in order to foster
ownership of the standards and codes assessments carried out under these
exercises and to promote market awareness of the value of the information
provided by these programs.
Looking forward, the priorities for institution building in the financial sec-
tor vary substantially by country. For instance, in reviewing the experience with
FSAPs, the IMF notes that deficiencies among emerging markets in financial
regulation and supervision relate mainly to the ability of supervisory authori-
ties to keep up with the proliferation of financial services, undertake risk-based
supervision, take prompt corrective action, deal with consolidated supervision
15
REPORT TO FINANCE MINISTERS AND CENTRAL BANK GOVERNORS
and cooperate with other domestic and foreign supervisory agencies. In the
case of industrialized nations, the challenges in institution building relate
mainly to the trend toward financial conglomerates, to electronic banking, to
the role of state banks, to reinsurance and to loan classification systems.
Notwithstanding these differences in emphasis, it may be useful to refer
to some of the areas, beyond those raised in the previous pages, where the
studies indicate that further action will be needed. The latter, which can also
be taken into consideration in delineating the future agenda of the G20,
include the following:
• Globalization requires greater international cooperation on financial
sector regulatory issues.
• With globalization, the exchange of information and the coopera-
tion between supervisory authorities and central banks should be
enhanced, in particular with a view to macroprudential and structural
monitoring of financial market developments, as well as in crisis
management.
• Globalization also calls for strengthening cross-sector cooperation in
order to respond to the greater degree of integration of financial
products, markets and intermediaries.
• With globalization, large and complex financial institutions have
emerged that raise risks for money and capital markets and for the
functioning of payment and settlement systems. Adequate monitor-
ing of the financial risks incurred by these institutions is highly
important from a systemic stability point of view.
• Limitations regarding preconditions for effective insurance supervi-
sion are widespread.
• The regulation and supervision of securities markets are also affected
by a number of weaknesses in many countries.
16
R EPORT TO
F INANCE M INISTERS AND
C ENTRAL B ANK G OVERNORS
P REPARED BY THE D EUTSCHE B UNDESBANK
B ERLIN , G ERMANY , 20–21 N OVEMBER 2004
This report reflects the main conclusions of this year’s inquiry of G20 deputies
into the priorities of institution building in the financial sector. Work began
under the Mexican presidency in 2003. As a basis for discussion, most G20
members submitted case studies, highlighting their experience of financial
sector development. At their annual meeting in Morelia on 26–27 October
2003, ministers and governors concluded that the analysis of the case studies
“has underlined the fact that solid institutions and sound, deep and sophisti-
cated domestic financial markets are key elements to maximize the benefits of
globalization, promote growth and significantly reduce the risk of financial
crises”. They agreed that these requirements should be given further consid-
eration in the future agenda.
In 2004 deputies discussed several specific aspects that were assessed in
the case studies as central to building stable and efficient financial sectors.
These issues include the features of an appropriate legal framework and the
crucial role of reliable payment systems. Strategies for developing strong
domestic financial markets were discussed in greater depth at a workshop with
academics and private sector representatives, co-sponsored by the Bank of
Canada and the Deutsche Bundesbank, in Ottawa on 26–27 April 2004.
Deputies also discussed organizational options for discharging the functions
of financial sector supervision. Finally, they assessed the technical assistance
for institution building provided by the IMF and World Bank.
L EGAL FRAMEWORK
An appropriate legal framework is crucial for developing a well performing finan-
cial sector. Legal systems that guarantee contract fulfillment and enforcement of
property rights (such as collateral assets) promote financial intermediation and
17
REPORT TO FINANCE MINISTERS AND CENTRAL BANK GOVERNORS
foster the development of deep and broad financial markets. To enhance judicial
effectiveness and legal certainty, it is also important to reduce corruption and
stimulate training efforts of judges and trustees.
Providing collateral is a standard method for containing credit risk and
reducing the cost of capital. Collateral is, in fact, generally a sine qua non for
gaining access to long-term bank borrowing. For collateral to fulfill its func-
tion, it is essential to ensure efficient enforcement mechanisms for the event
of insolvency or bankruptcy. Therefore, deputies welcomed the undertaking
of the World Bank to develop “Principles and guidelines for effective insol-
vency and creditor rights systems”. They assessed the draft principles with par-
ticular regard to the importance of accommodating differing legal traditions
and the specific needs of emerging market economies.
To serve as a viable best-practice reference and broadly based diagnostic
tool, the World Bank aims at a sufficiently flexible design of the principles to
accommodate a wide range of legal systems, cultures and procedures around
the world. To meet these requirements, the consultative process on the prin-
ciples involved more than 70 international experts from developed and devel-
oping civil law and common law countries. Since 2001, the draft principles
have been used to assess the insolvency and creditor rights systems of more
than 20 countries belonging to diverse legal cultures. The experience gained
was again reflected in the design of the principles.
Revised draft principles will be made available shortly. According to the
revised draft, especially relevant with regard to emerging market economies,
they accentuate abbreviated procedures for debt collection. For instance, they
emphasize the merits of simplified proceedings for the enforcement of unse-
cured rights by putting more weight on nonjudicial dispute resolution. This
is of particular importance for countries where lawsuits are costly and slow
owing to weak or inefficient judiciary systems. The revised principles also
express stronger support for maintaining the rights and priorities of creditors
in insolvency proceedings. Because any statutory intervention into creditor
rights could imply legal risk and delays, this recommendation would promote
long-termism by strengthening legal certainty, especially important in emerg-
ing jurisdictions. The revised principles recommend that common insolvency
proceedings should apply to all enterprises or corporate entities and that
exemptions from this rule should be very limited. In particular, they no longer
recommend exempting financial institutions from the general standard. On
the filing of insolvency or bankruptcy proceedings, the revised principles also
no longer envisage an automatic freeze of debtor assets. They advocate freezes
18
BERLIN
to be ordered and made public by courts. This change reduces the risk that
potential business partners remain uninformed about the freeze of debtor
assets.
PAYMENT SYSTEMS
Payment systems always constitute a central part of the financial infrastruc-
ture. Deficient payment systems lead to an inefficient use of financial
resources. They also increase the risk that an unforeseen default by a major
participant will seriously impair the stability and development of the finan-
cial sector, with subsequent implications for the real economy. Thus, the reg-
ulatory and operational framework of payment systems should have high
priority in the institution building process.
According to several case studies, reforms have been mainly directed at
enhancing operational efficiency, reliability, speed and timeliness of payment
transactions, while reducing or containing financial and most notably systemic
risks. Experience has shown that the development of payment systems has ben-
efited strongly from the active participation of the central bank. To provide
stable and efficient payment systems at any point in time, central banks have
to cope with some permanent challenges: securing reliable payment instru-
ments; continually enhancing their systems to meet the demands of the mar-
ket, especially in the field of innovations in payment products and procedures;
safeguarding cost-effective access of potential customers; strengthening the
resistance of the infrastructure to systemic risks; and ensuring adequate sur-
veillance under changing circumstances. When carrying out these tasks, cen-
tral banks should cooperate closely with market participants.
Especially for emerging market economies, building a nationwide cash-
less payment system to ensure market access to all banks should have prior-
ity over the adoption of state-of-the-art technologies by a limited number of
institutes. Deputies appreciated the involvement of emerging market
economies in the Bank for International Settlements–based Committee on
Payment and Settlement Systems because this will contribute to guidance for
developing a payment system that addresses their specific needs.
19
REPORT TO FINANCE MINISTERS AND CENTRAL BANK GOVERNORS
foreign investors into domestic currency instruments, thus reducing the need
for external funding in foreign currency. Discussions in Leipzig and Frankfurt
and, in particular, the Ottawa workshop (see also part III) contributed to a
fruitful dialogue on the design of an institutional framework conducive to
developing and maintaining stable and efficient financial markets.
The accumulation of serious currency mismatches has been a common
element in recent financial crises. Currency mismatches resulted from financ-
ing domestic activities through borrowing in foreign currency. In the event of
large exchange rate depreciations, debt service burdens in terms of domestic
currency suddenly increased. Financial intermediaries came under pressure
from mismatches in their own balance sheets or owing to corporate insol-
vencies. Deputies disagreed with a concept that ascribes currency mismatches
to the fact that emerging market economies are virtually unable to borrow on
the international markets in their own currency. They referred to small indus-
trialized countries that, with few exceptions, are unable to issue international
bonds in their own currency as well. Yet, these countries have developed sta-
ble and efficient financial sectors with strong banking systems and deep local
securities markets, which are also attractive to foreign investors, enabling these
countries to import capital denominated in their own currency.
Deputies stressed that over the past decade many emerging market
economies have already made substantial progress in strengthening their
domestic securities markets. Local bond markets have become the dominant
source of funding for governments in several important emerging market
economies. Nonbank institutional investors, particularly pension funds in
Latin America and insurance companies in Asia, have been driving forces
behind this development. But currency mismatches will remain a major source
of vulnerability for the foreseeable future, and further policy efforts are nec-
essary to contain the risks. The following five aspects have been broadly
endorsed as appropriate policy guidelines.
• First, sustained sound macroeconomic policies are an essential pre-
condition for the development of strong and efficient domestic finan-
cial markets. If inflation rates are high and volatile, broad and deep
bond markets in domestic currency cannot develop because creditors
will avoid long-term instruments or show a preference for foreign
currency assets.
• Second, government debt management can give a crucial stimulus to
the development of bond markets by providing a wide maturity range
of liquid securities that can assume benchmark functions and ensure
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21
REPORT TO FINANCE MINISTERS AND CENTRAL BANK GOVERNORS
22
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much more limited than supposed. This may be due partly to persisting dif-
ferences with respect to supervisory objectives. As banks transform rather liq-
uid liabilities into mostly illiquid assets, the banking sector is especially prone
to systemic risks by bank runs and contagion. The focus of banking supervi-
sion is therefore on the stability of the financial institutions. By contrast, the
relative illiquidity of long-term insurance contracts, such as life insurance
policies, lessens the risk that a failing institution could cause systemic insta-
bilities. So, insurance supervisors aim mainly at protecting the interests of
policyholders.
Further, an integrated supervisory system might not adequately address
unique characteristics of different business lines. If, for example, the banking
sector represents the dominant part of the financial system, integration could
come at the expense of proper supervision of nonbank industries or financial
markets. This is especially important in countries where financial industries and
markets as well as corporate governance and risk management are still little
developed and where strengthening externally imposed rules and their super-
vision should have a high priority. While the organizational framework can
enhance supervision, integration alone will not automatically improve regula-
tion and supervision that have been poor under decentralized systems. The
associated benefits of integration rely heavily on the assumption that supervi-
sion will be more harmonized and communication and coordination will be
improved. Yet, there could be losses in efficiency if the integrated approach
becomes excessively bureaucratic. Insufficient administrative reorganization
and adverse internal structures may not only impede the exchange of infor-
mation and coordination, the integrated system might then also react too slowly
to problems. Thus, a comprehensive plan and strong managerial skills would
be needed to realize possible advantages.
Deputies agreed that the debate about potential advantages of integrat-
ing financial sector supervision must also draw special attention to the role of
the central bank in maintaining financial stability. A central bank has a vital
interest in the financial soundness of commercial banks. They are the coun-
terparts on the money market and, therefore, an important transmission chan-
nel for implementing monetary policy. Moreover, financial instability could
affect the proper functioning of the payment system, with systemic risks in the
offing. So, the central bank is interested in prudential information on finan-
cial players. Since central banks closely monitor financial markets as their field
of activity, their involvement in the supervisory framework can also bring
about major synergy effects.
23
REPORT TO FINANCE MINISTERS AND CENTRAL BANK GOVERNORS
T ECHNICAL ASSISTANCE
The International Monetary Fund (IMF) and the World Bank Group pro-
vided deputies with an overview on the broad range of their technical assis-
tance (TA) in the field of institution building. While there are joint
engagements in several areas, the approaches also differ to some extent.
The IMF’s TA has tended to be geared mainly toward fostering monetary
and financial stability. The Fund has provided TA especially for countries
recovering from armed conflicts and seeking to build basic infrastructures.
Moreover, the IMF has assisted countries recovering from financial crises.
Here, the support focused on developing operational modalities for bank
restructuring, establishing asset management agencies, drafting bank insol-
vency and deposit insurance laws and enhancing supervisory capacities.
Financial sector assistance by the World Bank Group aims broadly at intro-
ducing frameworks conducive to promoting sustainable access to finance for
everyone. The main channel for promoting reforms remains financial support
to both governments and private sector entities through lending, investing and
guarantee activities. In addition, the World Bank Group provides a broad vari-
ety of advisory services. In particular, together with the IMF and a number of
24
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national donors, the World Bank has launched the Financial Sector Reform
and Strengthening (FIRST) Initiative, a project designed to promote robust
and diverse financial sectors in developing countries. FIRST provides TA grants
for capacity building and policy development in the areas of financial sector
regulation, supervision and development. The Reserve Advisory and
Management Program (RAMP) was established in 2001 to assist member cen-
tral banks in building world-class expertise in the management of their foreign
exchange reserves. A more recent tradition is a program to provide expertise
and advice in sovereign debt management for middle-income countries.
In the last few years, TA has often been motivated by countries’ desire to
achieve compliance with financial sector standards. IMF–World Bank
Financial Sector Assessment Programs (FSAPs) have allowed authorities to
evaluate institutional frameworks according to an international reference. This
permitted to identify gaps and to prioritize institutional reforms. The action
plan developed at the end of FSAPs has often been a starting point for later
TA. However, resource constraints are substantial.
Deputies stressed that future challenges arise mainly from TA having
become an increasingly sophisticated exercise. Many countries have emerged
from basic needs, partly reflecting past successes of institution building.
Therefore, TA demand has become much more specialized—such as that
related to Basel II, including stress-testing techniques and methods of man-
aging operational risks in the banking sector. Thus, deputies highlighted the
fact that future TA will have to draw more on national experts. To satisfy such
requests and to avoid duplication of work, enhanced cooperation by the IMF,
the World Bank, other international organizations, specialized bodies and
national authorities will be essential. An exchange of findings could be facil-
itated by making TA reports more broadly available.
25
PART II
29
CASE STUDIES AND CROSS-COUNTRY REVIEWS
30
AUSTRALIA
31
CASE STUDIES AND CROSS-COUNTRY REVIEWS
markets to become more global. This increased the pace of change in finan-
cial markets.
These changes also created new challenges for regulators. Innovation in
product design blurred the boundaries between financial instruments and insti-
tutions. With regulation still following largely institutional lines, providers
could exploit regulatory gaps. For example, there was a further proliferation of
nonbank financial institutions offering savings products that had the compet-
itive advantage of not being subject to the same stringent regulation as the
banks. Moreover, nonfinancial service competitors—such as retailers, airlines
and telecommunications companies—were entering the industry and offer-
ing financial services to consumers. These changes in the financial system led
to products and distribution channels expanding beyond the traditional cate-
gories of banking, insurance and stock broking. They also put pressure on reg-
ulators to ensure competitive neutrality in the treatment of like products
offered by different institutions.
Consumer sophistication was associated with new products and, impor-
tantly, the greater availability of information about those products. Together
with the aging of the population and government initiatives to promote retire-
ment savings, this led to changing consumer demands, particularly a decline
in the importance of deposits.
In addition to these broader forces of change, some developments in the
postderegulation environment provided pressure for further review of the
financial system. Corporate gearing increased significantly in the 1980s.
Underlying this trend was a rise in the number of highly leveraged corporate
takeovers from 1984 to 1987, with credit growth after 1987 driven largely by
a property boom.
Why the lowering in credit quality? Banks took some time to adjust risk
assessment procedures. In the deregulated environment, banks could take on
higher-risk borrowers. They also needed to take more account of exchange rate
and interest rate risk (Valentine 1991). In addition, high inflation, with a tax
system that provided incentives to borrow to finance capital investments, led
to large amounts of overborrowing as investors took advantage of rising asset
prices.
As interest rates rose in the late 1980s, the decline in credit standards
began to show up in significantly higher levels of nonperforming loans and
writedowns, resulting in substantial losses at two of the four largest banks,
the recapitalization or takeover of some state government–owned banks and
the closure of some nonbank financial institutions.
32
AUSTRALIA
T HE POLICY RESPONSE
Many issues raised throughout the 1980s and 1990s were overcome with the
appropriate regulatory adjustments, such as coordinated supervision of banks
and nonbank financial intermediaries as well as regulations for the insurance
and superannuation industries. But the financial system continued to undergo
sweeping change. And against this background, the government decided in
33
CASE STUDIES AND CROSS-COUNTRY REVIEWS
34
AUSTRALIA
Monetary policy
In the late 1970s and early 1980s, monetary policy in Australia was guided by a
target for annual growth in the monetary aggregate M3—referred to in the
Australian context as a “conditional projection”. This was in line with the prac-
tice in many other countries at the time. But financial deregulation saw the
demand for money, traditionally defined, become more unstable, and the rela-
tionship between monetary aggregates and inflation and nominal income broke
down. Monetary targeting was abandoned in 1985. In the absence of alterna-
tives, this left monetary policy to be set on a discretionary basis for the next few
years, though a “checklist” of economic variables was adopted for a period.
The persistence of relatively high inflation in Australia through the late
1980s and the desire for a more credible and intellectually robust framework
for monetary policy led Australia to adopt an inflation targeting regime in
1993. This took a less rigid form than some other countries, with the target
specified as an inflation rate between 2 and 3 percent on average over the
economic cycle. This was affirmed in the Statement on the Conduct of
Monetary Policy signed by the Treasurer and the Governor of the Reserve
Bank in August 1996. The statement also formally established the indepen-
dence of the Reserve Bank.
There is little doubt that the additional market scrutiny that came with
deregulation and integration with global markets added to the pressure to get
the monetary policy framework right. These same forces brought about
equally dramatic changes in the Reserve Bank’s operational framework, which
in turn put in place the basis for greater operational independence. The free-
ing of banks’ activities meant the abandonment of many early tools of mon-
etary policy—many in the hands of the government rather than the central
bank. In this new world it became possible for monetary policy to operate
through open market operations aimed at setting the overnight cash rate.
35
CASE STUDIES AND CROSS-COUNTRY REVIEWS
This, for the first time, provided a purely market-based mechanism for mon-
etary policy, that was entirely in the hands of the central bank.
Fiscal policy
Following the floating of the Australian dollar and the removal of capital con-
trols there was a sharper focus on the size of Australia’s current account deficit
and the savings-investment imbalance underlying the deficit. There was much
public debate on the “twin deficits” of the current account and the federal
budget—and greater pressure for a medium-term fiscal strategy that boosted
public savings and reduced pressure on the current account.
In the 1996–97 budget the government announced that it would imple-
ment a Charter of Budget Honesty. The charter was not to articulate any spe-
cific rules or objectives for fiscal policy but to specify transparency-oriented
requirements and guiding principles for the operation of fiscal policy. In 1998
the government adopted an explicit strategy to maintain budget balance, on
average, over the course of the economic cycle.
The government also undertook major reform of the tax system in 2000
with a goods and services tax based on the value added tax. The goods and ser-
vices tax removed a number of inefficient specific taxes and provided a broad
base indirect tax system to ensure a secure revenue base into the future. Reform
of the tax system has provided a more competitive and robust foundation in
face of increasing global competition for investment.
36
AUSTRALIA
Tax reform
Australia’s business tax arrangements have been modernized and improved.
The centerpiece of these reforms has been the significant reduction in com-
pany tax rates to an internationally competitive 30 percent. Capital gains tax
changes have provided further efficiencies by removing indexation and replac-
ing it with a halved rate of tax for individuals and trusts and exempting one
third of the gain for superannuation funds. As a further measure, tax rates for
different financial institutions were aligned as part of the business tax reforms
that started in 1999. These reductions were funded by complementary mea-
sures, such as the removal of accelerated depreciation, which broadened the
business income tax base.
Following a review of Australia’s international taxation arrangements, in
May 2003 the government announced a package of reforms to improve the
competitiveness of Australian companies with offshore operations. These
reforms will reduce the costs of complying with the controlled foreign com-
pany rules, reduce tax on foreign “active” business income and effectively
reduce foreign taxes by modernizing Australia’s tax treaties.
The reforms will encourage the establishment in Australia of regional
headquarters for foreign groups and improve Australia’s attractiveness as a
continuing base for its multinational companies. The reforms will also
enhance the competitiveness and reduce the compliance costs of Australia-
based managed funds.
The shift in Australia’s tax treaty policy follows changes Australia made to
its tax treaty with the United States through an amending protocol that entered
into force on the 12 May 2003. The protocol provides opportunities to sig-
nificantly enhance the international competitiveness of Australian businesses,
further improve Australia’s standing as a global financial center and increase
trade and investment flows between Australia and the United States. Of par-
ticular importance to Australian business are the reductions in the applicable
rates of withholding taxes including an exemption from interest withholding
tax for financial institutions.
37
CASE STUDIES AND CROSS-COUNTRY REVIEWS
The entry into force of a revised tax treaty with the United Kingdom in
2003 now means that approximately 70 percent of Australian outbound
investment benefits from the reduced withholding tax rates available under
Australia’s modernized tax treaties with the United Kingdom and the United
States. In the coming years, Australia is obligated to enter into negotiations
with Austria, Finland, France, Italy, the Republic of Korea, the Netherlands,
Norway and Switzerland with a view to providing similar treatment in rela-
tion to withholding tax rates as agreed with the United States. Modernized
treaties with these and other countries will serve to enhance Australia’s stand-
ing as a global financial center.
B ENEFITS OF REFORMS
The reforms to financial regulation over the past two decades have promoted
competitive pressures across the financial sector. In particular, competition in
such markets as home and personal lending has been enhanced through the
entry of foreign banks into the Australian market and the establishment of spe-
cialist providers in the home lending market.
While the entry of foreign banks enhanced competition in wholesale mar-
kets, they have struggled to make inroads in retail markets. The provision of
finance to small businesses remains concentrated at the four major banks.
And greater competition took a while to come through—suggesting that it
takes both deregulation and appropriate technology (which reduces the costs
facing new entrants) to produce an effective increase in competition.
Efficiency benefits
There is evidence that the increase in competitive pressures that flowed from
financial regulation reforms has improved efficiency in the financial sector.
Before the Campbell regulatory reforms in the banking sector, interest rate and
maturity controls resulted in a pricing structure that provided most retail pay-
ments and transaction services free of charge. The costs of these services were
offset against lower interest rates on deposits. As a result of these controls, the
banking system practiced considerable cross-subsidization among products and
customer groups. These cross-subsidies created distortions in pricing signals.
During the 1990s the pricing of these banking services began to reflect
more closely the user pays principle, creating stronger incentives for allocative
efficiency. For example, an extensive range of fees and charges for retail trans-
action accounts has been introduced by institutions providing deposit-taking
services.
38
AUSTRALIA
The Wallis Inquiry noted that, despite the rise in financial assets as a share
of GDP, the contribution of the financial sector to GDP has been declining.
That is, the financial sector has been managing more assets with fewer resources.
The inquiry found that these declining costs are primarily due to lower employ-
ment in the financial sector, driven by technological restructuring and enhanced
efficiency. Increased competition in the financial sector has provided an impe-
tus for domestic institutions to reduce their costs of production.
Deregulation has also seen significant dynamic efficiency benefits from
product innovation. Changes to financial regulation in the 1980s—such as the
removal of controls on interest rates and term deposit products and the entry
of foreign banks into the domestic market—increased both the range of prod-
ucts that banks could offer and the number of competitors in the finance sec-
tor. The competitive pressures on financial service providers to meet customer
needs have been further enhanced by the arrival of niche, nonbank service
providers in several profitable markets. The improved range of products avail-
able to consumers is highlighted by developments in debt and credit products.
Output benefits
While it is difficult to identify separately the benefits of individual reforms, the
integration of Australia into the global economy coincided with strong
improvements in productivity and income growth, both relative to historical
growth and to the Organisation for Economic Co-operation and Development
(OECD) average.
The Australian economy strengthened considerably in the 1990s with nine
years of persistent growth. This strong performance included 13 consecutive
39
CASE STUDIES AND CROSS-COUNTRY REVIEWS
quarters of through the year growth above 4 percent—the longest run of such
growth recorded in the history of the quarterly national accounts (since
September 1956).
Productivity performance
During the 1990s productivity growth rates in Australia returned to levels not
seen since the late 1960s. By the second half of the 1990s, Australia’s average
annual labor productivity growth was more than twice that recorded in the late
1980s, exceeding the OECD average. Similarly, Australia experienced strong
growth in multifactor productivity, highlighting the fact that Australia’s pro-
ductivity surge came from improvements in the overall efficiency of the econ-
omy, thanks to better management and work practices within industries—and
resource allocations to more productive industries.
Australia’s strong productivity growth was a payoff from sustained macro-
economic and structural reforms. Indeed, the OECD, in its 2003 Economic
Survey of Australia, noted that “dogged pursuit of structural reforms across a
broad front, and prudent macroeconomic policies set in a medium-term
framework, have combined to make Australia one of the best performers in
the OECD, and also one notably resilient to shocks, both internal and exter-
nal” (OECD 2003a).
Recent Australian and U.S. analysis, and new multicountry comparisons
have helped identify further reasons for the strong performance (Common-
wealth of Australia, Department of the Treasury 2003). In short, deregulation
and strong competition drove new work practices and encouraged rapid
Table 1
40
AUSTRALIA
Table 2
41
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Financial stability
Many of the financial stresses brought about by globalization affect the finan-
cial system directly or indirectly. Typically, currency mismatch problems
directly affect the soundness of banks since the banking system frequently
intermediates between foreign currency lenders and domestic firms. If hedg-
ing instruments are not available, the banking system either suffers directly by
taking on the foreign currency risk itself or indirectly by the default of domes-
tic firms that have borrowed from it in foreign currency. Maturity mismatches
can also create severe liquidity problems for financial institutions. In addi-
tion, high levels of capital inflows or domestic credit growth following liber-
alization often result in boom-bust cycles in asset prices, once again putting
pressure on financial institutions through declining credit quality and the
reduced value of collateral.
A precondition for weathering these stresses successfully is for the bank-
ing system to be well managed, well capitalized and well supervised. Deregu-
lation in Australia put pressures on the Australian financial system and
highlighted weaknesses in bank management and prudential supervision that
have since been addressed.
The disruption to the banking system was in many ways similar to that
experienced in many countries opening to foreign capital. Furthermore, the
institutional setting at the time was heavily influenced by the pressures of
opening markets. But the specific pressures were driven largely by freeing up
42
AUSTRALIA
domestic credit. Even so, the implications for financial supervision are the
same. This illustrates an important point—that sound institutions are neces-
sary irrespective of globalization, though globalization may increase the costs
of not having them.
While some areas in the Australian economy were not fully prepared for
financial liberalization—such as in the general understanding of foreign
exchange risks—the economy was able to absorb the cost of the transition.
This suggests that by the early 1980s, the economy had reached two critical
thresholds:
• The ability to manage currency mismatches, because Australian enti-
ties could borrow in domestic currency, both on domestic markets
and offshore.
• A sufficiently sound banking sector, which could absorb the losses
that arose at the end of the post-liberalization boom in asset prices.
There is a difficult tradeoff between institutional development and finan-
cial liberalization. Liberalizing before institutions are sufficiently sound can
make the benefits from liberalization ambiguous. On the other hand, liberal-
ization can hasten institutional development—for instance, by knowledge
transfers from foreign financial institutions participating in the local market.
These developments suggest that, even in fairly well developed and deep
markets, currency volatility raises some important management issues for
corporations. Such volatility may be more pronounced in markets that are
less developed and less liquid.
A variety of factors could assist in smoothing the transition to a liberal-
ized financial sector, the most important being the ability to borrow in domes-
tic currency and the soundness of the banking system. Australia seemed to
have reached or passed the thresholds in these areas by the early 1980s.
43
CASE STUDIES AND CROSS-COUNTRY REVIEWS
G OING FORWARD
Australia has sought to develop a regulatory framework flexible enough to
remain robust in the face of future changes in the global environment. The
financial sector has been one of the most vibrant in the Australian economy,
and this can reasonably be expected to continue over the foreseeable future.
The structure and operation of the financial sector will continue to evolve as
globalization, financial convergence and new technologies alter the business
environment. This suggests that regulating the financial sector will continue
to be a dynamic task.
The agenda for financial sector regulation in Australia can be split into two
broad groups. First, recent financial regulation reform packages are being
implemented in a process likely to require, in some cases, up to several years.
Second, several specific regulatory issues will likely need to be assessed over
the course of the next few years. The challenges going forward include:
• Continuing the reforms of financial services, general insurance and
corporate governance, complying with the recommendations of the
Basel Committee on Banking Supervision (expected to be complete
by 2007) and improving the safety of superannuation.
• Reviewing of the regulation of conglomerates. The development of
complex company structures, including intragroup transactions and
44
AUSTRALIA
N OTES
1. While one of the objectives of the Campbell Committee’s report was to
put banks back on an equal footing with other financial institutions, some
disadvantages remained for banks for some years, which may have influenced
the growth in merchant banks. These included requirements to hold statutory
deposits with the central bank and a proportion of assets in notes and coin or
government securities. The establishment of a merchant bank was also a pop-
ular means for foreign banks to establish a presence in Australia before the
decision to allow foreign bank branches in 1992.
R EFERENCES
Australian Bureau of Statistics. Various years. Australian System of National
Accounts. Catalogue Number 5204.0. Canberra.
Comely, B., S. Anthony, and B. Ferguson. 2002. “The Effectiveness of Fiscal
Policy in Australia—Selected Issues.” Presented at The Impact of Fiscal
Policy, Bank of Italy Research Department Fiscal Policy Workshop, March
21–23, Perugia, Italy.
Commonwealth of Australia, Department of the Treasury. 1999. Making Trans-
parency Transparent: An Australian Assessment. Canberra.
45
CASE STUDIES AND CROSS-COUNTRY REVIEWS
———. 2001. Budget Strategy and Outlook 2001–02. Budget Paper No. 1.
Canberra.
———. 2003. Budget Strategy and Outlook 2003–04. Budget Paper No. 1.
Canberra.
Costello, P. 1997. “Reform of the Australian Financial System.” Address to the
House of Representatives, by the Hon. Peter Costello, Treasurer of the House
of Representatives, September 2, Canberra.
Gizycki, M., and P. Lowe. 2000. “The Australian Financial System in the 1990s.”
In D. Gruen, and S. Shresta, eds., The Australian Economy in the 1990s.
Sydney: Reserve Bank of Australia.
Gollan, R. 1968. The Commonwealth Bank of Australia: Origins and Early History.
Canberra: Australian National University Press.
Kenwood, A. 1995. Australian Economic Institutions Since Federation: An Intro-
duction. Melbourne: Oxford University Press.
KPMG Australia. 1995. “Financial Institutions Performance Survey.” KPMG
Australia, Sydney.
———. 1996. “Financial Institutions Performance Survey.” Sydney.
———. 2002. “Financial Institutions Performance Survey.” Sydney.
Lewis M. K., and R. H. Wallace. 1997. The Australian Financial System: Evolution,
Policy and Practice. Melbourne: Addison Wesley Longman.
OECD (Organization for Economic Co-operation and Development). 2003a.
Economic Survey of Australia. Paris.
———. 2003b. The Sources of Economic Growth in OECD Countries. Paris.
Peat Marwick Mitchell and Co. 1985. “Banking in Australia.” New York.
Reserve Bank of Australia. 2002. “Innovations in the Provision of Investor
Finance.” Reserve Bank Bulletin, December.
———. 2003. “Banking Fees in Australia.” Reserve Bank Bulletin, April.
Valentine, Tom. 1991. “What the Campbell Committee Expected.” In I.
Macfarlane, ed., The Deregulation of Financial Intermedaries. Sydney: Reserve
Bank of Australia.
46
C ANADA
Financial systems are key elements of economic welfare. In Canada, as else-
where, the financial system is large and complex, composed of financial insti-
tutions, financial markets where financial assets are priced and traded, and
clearing and settlement systems that facilitate the flow of assets among firms
and individuals. Examining a financial system’s elements and their inter-
relationships facilitates understanding its evolution. This case study provides
a selective account of the Canadian financial system’s evolution, drawing on
five papers that together discuss each of the major components mentioned
above.1
Two papers by Freedman and Goodlet (1998a, 2002) examine ongoing
change in financial services while emphasizing the sector’s substantial inno-
vation. Daniel (2002) surveys the continuous review and change of finan-
cial sector regulation since the early 1990s. Freedman and Goodlet (1998b)
discuss the major changes for large-value payment systems. They and
Daniel also discuss related legislative changes. And Nowlan (2001) presents
a case study of past successful efforts to foster a robust money market in
Canada.
47
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Technology
Perhaps the most important factor propelling change has been technology,
which has, among other things, facilitated important developments for back-
office efficiency, new financial instruments and organization, and service deliv-
ery mechanisms for the household sector.
Technological developments, particularly in the electronic processing of
transactions, have enabled financial institutions to increase the efficiency of
their back offices. Canadian financial service providers have continued to
search for efficient ways to operate their back offices using three strategies:
building it, buying it and borrowing (through outsourcing).
Because of technological change, the optimum scale of activities in many
back-office operations has increased. As a result, some financial service
providers are trying to gain the largest market share in Canada for particular
activities (for example, transactions processing). Having decided that they will
be unable to achieve a sufficient size of operations to be efficient at some activ-
ities, other financial service providers are exiting these service areas and then
purchasing them from low-cost providers (including, for example, credit card
processing and payment processing services, such as debit card acceptance
services). Financial service providers continue to emphasize the need for each
product or service to be profitable. Some financial service providers have rig-
orously assessed the profitability of each business activity to allocate resources
toward activities of high strategic value and sustainable profitability, and to exit
areas that are not profitable (for example, noncore subsidiaries or certain lend-
ing activities).
Many functions offered by the financial system used to be provided as
joint products and could not be disentangled or unbundled. Recent techno-
logical changes have led to new instruments that permit these joint products
to be unbundled, financial components to be restructured into a variety of new
products, and separate services to be delivered by different entities.
At the same time, some financial service providers have adopted strate-
gies to rebundle products and services, particularly where economies of scope
are significant and especially in consumer and corporate lending. For exam-
ple, some banks are linking their willingness to extend corporate loans with
the readiness of customers to undertake their capital market business (such
as underwriting) with the bank.
In the late 1990s the use of electronic money was expected to expand
more rapidly than has actually been the case. The stored-value card, even more
so than earlier payment system developments (such as credit cards and debit
48
CANADA
cards), is a close substitute for bank notes and coins for small-value, face-to-
face payments, thus offering the possibility of being able to more effectively
meet consumer demand for such payment services. Network money and dig-
ital cash, on the other hand, involve funds, a liability for the issuer, held on
computer software that could be used to pay for purchases on the Internet.
Electronic money was introduced several years ago with great fanfare, and
although technically feasible, it does not appear economically viable at this
time. The potential revenue from a fully functioning arrangement appears
insufficient to offset the high cost of a national infrastructure to support such
a scheme. Expectations of a rapid deployment of electronic money schemes,
using either stored-value cards or network money, have nearly disappeared.
Mechanisms for delivering financial services and products continue to
evolve. A broader range of delivery channels has been developed, including
expanded use of automated banking machines, computer banking, and the
Internet to handle routine, low-margin financial transactions. Branches still
have a central role in financial service providers’ plans, but their nature is
changing (a strategy called “bricks and clicks”). Branch staff must now have
different qualifications, better training, and access to much better information
technology. Branches are also being opened on the premises of nonfinancial
companies. Emphasis is shifting at some financial service providers to rev-
enue from distributing financial services and products and from developing
and operating Web-based auction sites. But there continue to be significant
barriers to financial service providers’ use of information technology in the
innovation of products and services and their delivery channels.
Competition
A second key factor affecting recent financial sector developments is the chang-
ing competitive environment. Government actions to promote competition
have become common, as policymakers in many countries have taken the view
that additional competition in their country’s financial sector would be bene-
ficial for customers (subject to an acceptable level of safety and soundness
within the sector). Structures that inhibited competition are being dismantled.
In Canada, for example, the legal basis for the traditional compartmentaliza-
tion of the financial sector into specialized sector groupings has disappeared.
One result is the heavy involvement of banks in securities and trust businesses.
A second reason for the change in the competitive environment is the
growing internationalization of the financial services industry, defined here as
the spread of financial service providers across borders. Regulated financial
49
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Household demographics
Trends in household demographics, which have been largely responsible for
the gradual change in the desired asset-liability structure of household port-
folios, have also spurred change in the financial sector. As the populations of
North America, Western Europe, and Japan have aged and as income levels and
wealth have increased, there has been a slow but steady shift away from
credit products (such as consumer loans and home mortgages) to wealth-
management products (such as pension funds and mutual funds). This has
had a number of repercussions on the financial sector: rapid growth of pen-
sion funds and other institutions providing wealth-accumulation products
for retirement, increased demand for investment advice by households as their
portfolios have grown, and more interest in buying and developing entities
that provide mutual funds.
50
CANADA
51
CASE STUDIES AND CROSS-COUNTRY REVIEWS
discussed models seeks to regulate certain lines of business in the same way,
regardless of the nature of the provider. An alternative model has different
regulators dealing with different functions of regulation rather than different
business line functions.
The supervisory processes for entities still subject to solvency regulation
might also have to change. Supervisors may, for example, become less con-
cerned with the particular state of risk at an entity at a point in time. Instead,
they may focus more on the processes followed by a financial service provider’s
management and board of directors when determining the acceptable level of
risk, and in the way they monitor the financial service provider’s implemen-
tation of their decisions.
Policymakers also face the issue of how to deal with residents’ conduct-
ing transactions with financial entities situated abroad, particularly transac-
tions carried out on the Internet, which are often referred to as “cross-border
transactions”. New technology perhaps creates a greater possibility that trans-
actors are unaware of the extent to which a foreign financial institution offer-
ing services over the Internet is adequately supervised and regulated as well
as subject to appropriate consumer protection legislation.
52
CANADA
53
CASE STUDIES AND CROSS-COUNTRY REVIEWS
54
CANADA
55
CASE STUDIES AND CROSS-COUNTRY REVIEWS
56
CANADA
low cost of a system using netting or some other means of saving on collateral.
The Canadian large-value transfer system (LVTS) is one such system.
The LVTS began operation in February 1999. The developers worked
closely with authorities to minimize the potential for systemic risk. While
safety-related objectives were key, efficiency concerns also meant that consid-
erable effort was devoted to containing the costs of running the system, espe-
cially the cost of collateral. The LVTS uses multilateral netting arrangements
to reduce total exposures (for a given volume of payments) in the system and
subjects each participant to a cap on the total amount of exposure it can cre-
ate in the system. Any exposure created by an individual participant through
using intraday credit is fully collateralized, either directly by a participant on
its own behalf or indirectly by other participants. Moreover, the single largest
possible default to the system is fully collateralized by system participants, so
that the system is robust to the failure of any one of its participants. At the end
of the day, the overall multilateral net amounts to be paid and received are set-
tled among the participants on the books of the Bank of Canada.
To deal with some drawbacks in the structure of the LVTS, the Bank of
Canada took two initiatives. First, it guarantees all participants that the LVTS
will settle under all circumstances. This resolves the problem raised by the
extremely unlikely possibility of the unanticipated failure of more than one
participating institution with the amount owed to the system greater than the
available collateral. Because system participants collateralize the single largest
possible default in the system, a very large element of coinsurance is built in,
which motivates participants to manage their risks well. In addition, the Bank
of Canada established a new form of collateral for the LVTS, called “Special
Deposit Accounts”, which participating institutions may choose to use and
should find considerably cheaper than pledging Treasury bills.
When the LVTS was designed, all potential participants were Canadian-
incorporated entities, which assured that Canadian laws would be applied to
deal with insolvency in the event of a participant failure. Once the June 1999
legislation permitted foreign-bank branching, a branch established in Canada
by a foreign bank that wished to directly participate in a major Canadian clear-
ing and settlement system was required to provide a legal opinion on several
issues, including the enforceability of netting and collateral arrangements if a
foreign bank failed.
The LVTS controls systemic risk differently from the typical RTGS system,
but it has all the essential attributes of an RTGS system. The key characteris-
tic is that each payment message will be processed in “real time” and subject
57
CASE STUDIES AND CROSS-COUNTRY REVIEWS
to risk control mechanisms. In all but the most extreme situations the partic-
ipating institutions will bear the loss of a participant failure, which provides
a strong incentive for participants to appropriately manage risks in the system.
58
CANADA
59
CASE STUDIES AND CROSS-COUNTRY REVIEWS
60
CANADA
and by the end of the 1960s, the foundation had been laid for a growing,
vibrant money market in Canada.
Subsequent developments
Following the period of intense market building, the Bank of Canada, work-
ing with the Department of Finance and market participants, has introduced
many technical improvements in Canada’s financial market’s operations. Since
the mid-1970s, the market for government of Canada Treasury bills and mar-
ketable bonds has shown innovation and, until the mid-1990s, rapid growth.
Over the years, the Bank of Canada and the Department of Finance have
worked to improve the efficiency of Canadian capital markets through their
own initiatives and by supporting those of others, including various regula-
tory agencies. This cooperative approach to market development has created
an active market for short-term corporate paper and has led to the introduc-
tion of numerous new products, such as short-term interest rate derivatives
(for example, bankers’ acceptances future contracts, called BAX, traded on the
Montreal Exchange, and many over-the-counter derivative products).
The initiatives of the 1950s and 1960s laid the groundwork needed to
develop the fixed-income market in Canada into one of the most vibrant mar-
kets by international standards by the mid-to-late 1980s. In light of the sig-
nificant improvement in the government’s financial position in recent years
(including an absolute drop in the amount of outstanding market debt),
efforts are now directed at preserving the integrity and efficiency of the mar-
ket for government securities in an era of declining supply. The Bank of
Canada has, for example, adjusted its own participation at the regular Treasury
bill and bond auctions to mitigate as much as possible the effects of declining
net new issuance. Other measures have been adopted to maintain and enhance
market liquidity and efficiency, such as changes to the auction rules for gov-
ernment securities and their oversight by the Bank of Canada, as well as a
code of conduct in secondary markets for fixed-income products in Canada
adopted by the Investment Dealers Association of Canada.
Canada’s approach pursued almost 40 years ago may not be entirely
appropriate today. In particular, Canadian authorities showed preferential
treatment to domestic banks and dealers to encourage them to become more
active in Canadian fixed-income markets, especially those for government of
Canada securities. Even today, primary dealers of government of Canada secu-
rities are required to maintain trading operations in Canada in order to have
direct access to auctions and, for some, lines of credit from the Bank of
61
CASE STUDIES AND CROSS-COUNTRY REVIEWS
N OTES
1. Recent developments in the financial system are regularly surveyed in the
Bank of Canada’s Financial System Review, published in June and December of
each year. This and other relevant material on the financial system may be found
on the bank’s Web site, www.bankofcanada.ca.
2. Economies of scale and scope refer to the possibility that a firm will real-
ize a reduction in the cost of producing goods and services as a result of an increase
in the size and breadth of its activities.
3. Self-dealing refers primarily to transactions between a financial institution
and either its controlling ownership group or nonfinancial and unregulated finan-
cial affiliates controlled by the owner.
4. For additional information on the phasing out of reserve requirements, and
its impact on the conduct of monetary policy in Canada, see Bank of Canada
(1999).
5. The limit for major banks had effectively been 10 percent.
6. For a concise description of the current structure of Canadian payments
and clearing systems, see the box entitled “Clearing and Settlement Systems in
Canada” in Bank of Canada (2003), p. 29.
7. The LVTS was designated under the act upon its introduction.
8. The June 1999 legislation included a provision to allow the governor of the
Bank of Canada to prohibit or impose conditions on the participation of a full-
service branch or a lending branch of a foreign bank in a clearing and settlement
system designated under the PCSA if the governor believes that its participation
poses, or is likely to pose, a systemic risk or an unacceptable risk to the Bank of
Canada (see Daniel 2002, p. 8).
R EFERENCES
Bank of Canada. 1999. The Transmission of Monetary Policy in Canada. Ottawa.
———. 2003. Financial System Review December.
Daniel, Fred. 2002. “Recent Changes to Canada’s Financial Sector Legislation.”
Bank of Canada Review Winter 2002–2003: 3–16.
Freedman, Chuck, and Clyde Goodlet. 1998a. “The Financial Services Sector: Past
Changes and Future Prospects.” Technical Report 82. Bank of Canada,
Ottawa.
62
CANADA
63
C HINA
Financial globalization is a process not only of financial activities tran-
scending national borders but also of risks spreading across markets. It is
initiated by many microeconomic entities that seek profits. It is driven by
the integration of global financial markets. A gradually deepening process
with different phases, it covers five areas: capital flows, monetary systems,
financial markets, financial institutions and financial coordination and
supervision.
China’s institution building in the financial sector takes place against the
backdrop of this financial globalization. It shares features with other countries
but also has its own characteristics. A review of the developments of China’s
financial sector over the past 20 years reveals that reform and opening have
been driving institution building in the financial sector. The fundamental rea-
son for financial system reform is to increase the efficiency of allocating and
using financial resources. Market-oriented, the reform aimed to establish an
advanced financial system and a sound financial order commensurate with the
socialist market economy.
Opening of the financial industry is an important part of China’s whole
opening strategy. Full contact with international markets means that China
can gain access to more global economic resources and expose the domestic
financial market to the forces of global financial markets, both positive or
negative.
64
CHINA
65
CASE STUDIES AND CROSS-COUNTRY REVIEWS
66
CHINA
gain speed. And after China’s accession to the WTO, more foreign enter-
prises are doing business with foreign banks. Meanwhile, premier domestic
enterprises are shifting to the securities market for financing, increasing
competition in traditional banking. Inadequate innovation, weak competi-
tiveness and the loss of premier customers and professional staff are more
salient for state-owned banks. And their heavy burden of nonperforming
loans, a long-lasting difficulty, hinders the restructuring of their ownership.
Moral hazard
The government has taken measures to prevent and dissolve financial risks since
1996. But the measures have not yet solved the problem of incomplete con-
tracts, and have instead created a moral hazard. The government took a leading
role in most mergers and acquisitions, which were not completely the result of
market selection. The operations of the merged and acquired financial institu-
tions have not changed fundamentally, though the number of branches and
staff has increased. In China’s case, as elsewhere, the bigger the financial insti-
tutions, the less possible it is for them to be closed. The government-guided
mergers and acquisitions reduce the probability of failure, but its assistance does
not necessarily improve management and asset quality.
67
CASE STUDIES AND CROSS-COUNTRY REVIEWS
68
CHINA
This contributed to financial stability not only in Asia but also in the whole
world.
69
CASE STUDIES AND CROSS-COUNTRY REVIEWS
70
CHINA
Roles of the government and the central bank in bond market development
The central bank acted as the designer and promoter of the OTC market—and
organized and established the interbank bond market. Macroeconomic pol-
icy measures by the government since 1997 also contributed to the rapid devel-
opment of the interbank market, including the issuance of special book-entry
Treasury bonds to commercial banks (for part of banking reform) and large
amount of treasury bonds and policy financial bonds to boost domestic econ-
omy. The interbank market has also become the major marketplace for the
central bank’s open market operations, and its liquidity has continued to
increase.
The central bank also encouraged market-based bond issuance, drawing
on good international practice. For example, it made Treasury bond issues
more market-oriented by adopting the bidding-based approach in 1999. And
it has enhanced the market infrastructure. For example, under the instruction
71
CASE STUDIES AND CROSS-COUNTRY REVIEWS
of the central bank, the China Government Securities Depository Trust &
Clearing Co. developed and improved the bond depository and clearing sys-
tem, strengthening the risk prevention capability of this market.
72
CHINA
3.0
2.5
2.0
1.5
1.0
0.5
0.0
1980 1985 1990 1995 1999
73
CASE STUDIES AND CROSS-COUNTRY REVIEWS
70
50
40
30 State budget
Domestic credit
20
10 Foreign funds
0
1981 1985 1990 1995 1999
74
CHINA
1.5
1.2
0.9
0.6
0.3
0.0
1981 1985 1990 1995 1999
75
CASE STUDIES AND CROSS-COUNTRY REVIEWS
76
CHINA
77
CASE STUDIES AND CROSS-COUNTRY REVIEWS
78
CHINA
79
F RANCE
In less than 20 years the French banking system has shifted from heavy pub-
lic involvement to nearly complete privatization. The rationalization of bank-
ing structures has created a much more liberalized environment. The number
of credit institutions has been reduced, creating a more concentrated mar-
ketplace, and some institutions that played a major role in French banking his-
tory have disappeared. But the openness of the French banking system has
greatly improved. Foreign banks are taking a significant market share in some
business sectors, and foreign ownership of French credit institutions is more
widespread. Banking products and services have also changed considerably
since controls were abolished on prices, credit and foreign exchange.
80
FRANCE
shaped the development of France’s banking system. Yet in 1965 the govern-
ment showed the first signs of gradually disengaging, and this shift initiated
the development of a modern banking system.
Reforms in 1966 and 1967 made rules more flexible and put an end to
promoting “despecialization”. The three main purposes of the reforms were to
ease banking restrictions for specialization, to stimulate competition between
banks by giving them freedom to open new branches and to improve financial
techniques. Deposits grew rapidly, especially after it became easier to open new
branches. The number of bank branches doubled between 1967 and 1975.
Until 1966 foreign banks had played only a small role in France’s bank-
ing system. But starting in 1967, their presence increased substantially. In 1970
they accounted for just under 10 percent of the banks in France and in 1980
about 15 percent.
As many local banks were shut down or merged into larger banks, the
average size of banks increased, and concentration intensified. For example,
the 1966 merger of Banque Nationale pour le Commerce et l’Industrie and
Comptoir National de Paris gave birth to Banque Nationale de Paris (BNP).
Despite the changes, many economists still felt that France’s banking sys-
tem was not flexible enough and that the excessively compartmentalized mar-
ket was a barrier to entry, hampering bank financing.
81
CASE STUDIES AND CROSS-COUNTRY REVIEWS
allowed to receive funds from the public at sight or at less than two
years’ term).
• Securities houses are financial companies whose principal business
is to manage securities portfolios on their customers’ behalf, receiv-
ing funds and management authority for this purpose, or to assist on
a del credere basis in the placement of such securities.
• Specialized financial institutions are credit institutions carrying out
a permanent public-interest task assigned to them by the state. They
may not carry out banking operations other than those relating to
this task, except as a secondary activity.
The Banking Act still provided for several categories of credit institutions,
but it did promote greater uniformity of banking products and services (box 1).
Despite the large number of institutions covered by the Banking Act, its
universal application was not total. The Trésor, the National Central Bank
(Banque de France), the Institut d’Émission des Départements d’Outre-Mer,
B OX 1
82
FRANCE
83
CASE STUDIES AND CROSS-COUNTRY REVIEWS
84
FRANCE
2,000
1,500
Credit institutions
1,000
500
Investment firms
0
1984 1986 1988 1990 1992 1994 1996 1998 2000 2003
Source: DECEI.
lending and 82 percent of deposits. The top 10 banking groups control more
than 85 percent of the retail banking business in France.
Ongoing renewal of the French banking system’s composition over the last
10 years has led to extensive changes in ownership. These changes reveal the dis-
engagement of the state, the growing role of mutual and cooperative institu-
tions and the emergence of some groups on a European or international scale.
85
CASE STUDIES AND CROSS-COUNTRY REVIEWS
86
FRANCE
HSBC
Royal Bank of Scotland
UBS AG
Barclays
BNP Paribas
ING Groep NV
HBOS
BSCH
BBVA
Lloyds TSB
Société Générale
Deutsche Bank
Crédit Agricole
Credit Suisse Group
ABN AMRO Hold
Unicredito SPA
Fortis NV
Banca Intesa SpA
Nordea Bank AB
Standard Charter
Dexia CC
KBC Bank Holding
San Paolo IMI
Allied Irish Banks
HypoVereinsbank
Banco Popular Español
SE Banken AB
Commerzbank AG
Monte Pashi
Capitalia
Bankiter
0 30 60 90 120 150
Source: Reuters.
87
CASE STUDIES AND CROSS-COUNTRY REVIEWS
88
FRANCE
89
CASE STUDIES AND CROSS-COUNTRY REVIEWS
tutions and investment firms (the Comité des établissements de crédit et des
entreprises d’investissement) or to insurance companies (the Comité des entre-
prises d’assurance) and one in charge of supervision (the Commission bancaire
for the banking sector and the Commission de contrôle des assurances des
mutuelles et des institutions de prévoyance for the insurance sector).
The law also aims at improving corporate governance and consumer pro-
tection and at clarifying the authority for competition policy in the banking
system.
90
G ERMANY
Germany’s financial system has proved very robust over the past 50 years.
Unlike several other developed nations, it has been spared systemic crises.
The system’s volume and structure can be gauged by the funds invested
or raised within the system by nonfinancial sectors and nonresidents. At the
end of 2003, the outstanding amount that households, nonfinancial enter-
prises, the government and nonresidents had invested in the German finan-
cial system represented about 407 percent of gross domestic product (GDP)
(table 1), which is close to the figure for the United States.1
In contrast to the clear capital market orientation of the United States
and other Anglo-Saxon countries, the German financial system can be con-
sidered a hybrid, lying somewhere between a purely bank-based and a purely
market-based system. By the end of 2003, German nonfinancial sectors
channelled financial investments equivalent to about 174 percent of GDP to
intermediaries, 91 percent to banks and 90 percent to the capital market.
These figures understate the intermediation role played by banks, since
banks are the most important issuers of securities. At the end of 2003, they
had net outstanding issues to refinance their business amounting to 75 per-
cent of GDP.
A noteworthy feature of the German financial system is the fact that credit
institutions operate mostly as multibusiness “universal banks”, offering invest-
ment banking, loans and other financial services. They usually operate as
“house banks” of their commercial clients. These long-term relationships may
help banks evaluate risks.
The large number of banks in Germany ensures strong competition
between institutions, but it also squeezes their profitability. While the market
shares of most individual banks are small, Germany’s five largest credit institu-
tions account for about 28 percent of the banking system’s total assets. This fig-
ure is similar to that in the United States (27 percent) and Japan (30 percent).2
Germany’s financial system has not changed dramatically over the past
few decades, mainly because major steps to deregulate the system and liber-
alize international capital movements occurred very early. Since the mid-
1980s, however, Germany’s capital market orientation has gradually increased,
helped by a large number of reforms in response to the enhanced competition
among national financial systems in the context of globalization and growing
European integration. While corporate bonds still make up only a small frac-
tion of the securities market (which is dominated by bank and government
91
Table 1
Volume and structure of the German financial system, year-end 2003 (percent of GDP)
Funds invested Funds raised
Deposits, loans, mutual Shares Deposits, loans, mutual Shares
funds and other claims and other funds and other liabilities and other
Sector Total Banks securities Total Total Banks securities Total
Resident nonfinancial sectors 174 91 90 264 165 127 119 283
Households 137 62 39 177 72 69 — 72
Corporations 26 19 47 73 70 38 74 144
General government 10 9 4 14 22 20 45 67
Resident financial sectors 230 74 118 348 235 97 97 332
92
Banks 186 51 65 251 146 89 90 236
Insurance companies 40 20 18 58 50 1 7 56
Investment funds 4 4 35 39 39 7 0 39
Nonresidents 68 43 74 143 63 55 67 130
Total 472 208 283 755 462 278 283 745
Memo item:
Total excluding resident
CASE STUDIES AND CROSS-COUNTRY REVIEWS
financial sectors 242 165 164 407 228 182 186 413
— Not applicable.
Note: Figures may not sum to totals because of rounding.
Source: Deutsche Bundesbank.
GERMANY
bonds), funding through the stock market has become significantly more
important in recent years, although it is still at a relatively low level. The mod-
ernization of the German financial system has also allowed insurance com-
panies and mutual funds (most of which belong to banks) to play a more
significant role as financial intermediaries.
Among the most important institutional innovations of recent years were
the creation of the Federal Securities Supervisory Office and the Federal
Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsauf-
sicht, or BaFin), which combines the tasks of the previously separate supervi-
sory agencies for banks, insurance companies and securities markets under
one roof. Exercising exclusively all sovereign functions and supervisory actions,
BaFin closely cooperates with the Bundesbank, whose role in supervising banks
and investment firms has been strengthened.
Institution building, in the sense of ensuring the efficient functioning of the
financial system, has also progressed in the field of payments. The Bundesbank
remains involved in providing payment services, while leaving most operational
tasks to the private sector. This system ensures equal access to payment services,
enhances its reliability and efficiency and increases the Bundesbank’s expertise
required to competently perform its oversight function.
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
Economic governance
Economic governance in Germany is guided by the concept of a “social mar-
ket economy”, a term popularized by Ludwig Erhard, the Federal Minister
of Economic Affairs from 1949 to 1963. A social market economy is an eco-
nomic system in which, in line with the underlying principles of the German
constitution, market forces are largely given a free rein while the state defines
certain “rules of the game” and, where necessary, seeks to ensure equality of
opportunity and social equity. Market forces clearly prevailed in the real
economy after World War II. Later the state increasingly intervened with
regulatory measures and tax increases aimed at achieving a more even dis-
tribution of income and other welfare objectives. These interventions tended
to reduce the efficiency of market forces. Moreover, the labor market is no
longer proving flexible enough to respond satisfactorily to structural
changes. Current economic policy in Germany is focusing on strengthening
the market elements of a historically very successful concept of economic
governance.
Price stability
Economic governance based on the principles of a social market economy is
reflected in the way German monetary policy was organized after World War
II. The German parliament mandated that the Deutsche Bundesbank, estab-
lished in 1957, manage the supply of money and credit with the objective of
safeguarding the purchasing power of the Deutsche mark. The new institu-
tion was to continue the successful policy pursued since 1948 by its prede-
cessor, the Bank deutscher Länder, a decentralized system of Land central
banks, with headquarters in Frankfurt. The Bundesbank was also assigned the
task of ensuring an efficient system of domestic and cross-border payments.
These functions highlight the Bundesbank’s special responsibility for mon-
etary and financial stability in the interplay among the various policymak-
ers. By focusing strictly on price stability, the Bundesbank helps ensure that
prices fully perform their information and allocation functions and that less
well-off groups are not discouraged from contributing to their social secu-
rity by saving. The Bundesbank also allowed lending in Germany to be based
on long-term contracts. “Long-termism” thus became a key feature of the
German stability culture.
The most important institutional feature of the German central bank
after World War II has been its complete independence from the federal gov-
ernment. The Bank deutscher Länder—established in 1948, before the
94
GERMANY
95
CASE STUDIES AND CROSS-COUNTRY REVIEWS
96
GERMANY
The German Civil Code provides for two possibilities: the accessory mort-
gage and the nonaccessory land charge. An accessory mortgage requires the
existence of an underlying obligation (typically a loan); the nonaccessory land
charge is valid independently of such an underlying claim. Both allow for the
sale of the encumbered real estate through a court-organized auction. In prac-
tice, the land charge is widely preferred, since it does not require the cumber-
some link to an underlying obligation.
The Insolvency Code adopted in 1999 ensures efficient enforcement of
creditor rights, but it also introduced a few minor restrictions to prevent
premature dissolution of the debtor. It provides collateralized creditors with
the right of satisfaction from the asset outside the normal insolvency pro-
ceedings.5 In addition, preferential treatment applies to creditors con-
tributing “fresh money” to the insolvent company. These creditors rank
ahead of general insolvency creditors. The very flexible and efficient use of
collateral under German law has been the foundation for EU directives on
collateral legislation.
97
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Table 2
The cooperative bank sector includes the largest group of institutions, with
almost 1,400 banks at the end of 2003 (table 2). The cooperatives were created
in the 19th century, in response to the inadequate provision of banking services
in the regions. They originally focused on small businesses and farmers, who are
still their main owners. The underlying principles are those of self-help and sol-
idarity. The cooperative banks have private-law status.
Commercial banks account for about 35 percent of business volume, sav-
ings banks for almost 40 percent and cooperative banks for more than 10 per-
cent (specialized institutions account for the remainder). Bank mergers and
acquisitions have occurred exclusively within each of the three types of insti-
tutions, and the three types of banks remain in sharp competition with each
other.
Each type of banking institution has a national association, which pro-
motes cooperation among its members, thereby increasing their members’
competitiveness. The associations also play an important role within the over-
all prudential framework by providing deposit-protection schemes.
Supervisory framework
German banking supervision is rooted in market-based principles. The man-
agers of credit institutions bear sole responsibility for their businesses. Banks
may disappear from the market as a result of mergers, takeovers or insolvency.
The supervisory authorities do not intervene directly in the institutions’ opera-
tions. Instead, banks are required to respect general quantitative and qualitative
provisions, open their books to the supervisory authorities and provide other
98
GERMANY
B OX 1
Licensing
• Has the minimum initial capital been paid in?
• Are the managers trustworthy? Do they have the required qualifi-
cations (theoretical and practical skills, managerial experience)?
• Are the organizational arrangements for the proper operation of
the business in place?
Ongoing monitoring
• Evaluation of monthly returns, annual accounts and auditor reports.
• Monitoring of compliance with capital requirements.
• Assessment of liquidity.
• Examination of permitted maximum amount of ownership shares
in other firms.
• Monitoring of large exposures.
• Monitoring of loans of €1.5 million or more.
• Exchange of views with managers and auditors.
Crisis management
• Warning or dismissal of managers.
• Ban on the distribution of profits or granting of loans.
• Ban on taking deposits.
• Ban on payments and sales.
• Temporary closure of business.
• Transfer of management powers to a special commissioner.
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
During the past two decades, amendments to the Banking Act have been
shaped by the harmonization of EU prudential legislation as Europe moves
toward a single financial market. Important developments were the harmo-
nization of the licensing criteria for credit institutions and investments firms,
the harmonization of capital requirements and the recognition of home coun-
try control for branches of credit institutions and investment firms from coun-
tries outside the European Economic Area.
Organizational features. The tradition of involving the central bank in bank-
ing supervision existed in Germany before the adoption of the Banking Act. As
the result of a systemic banking crisis, ongoing supervision of all banks was intro-
duced for the first time in 1931. This task was first conferred on a special body
controlled by the central bank (which itself was controlled by the government).
In 1939 legal responsibility for supervision was transferred to a newly established
supervisory office reporting to the government, while the central bank remained
responsible for material supervision.After World War II, banking supervision was
initially decentralized under the responsibility of the states, which relied on the
Bank deutscher Länder and later the Bundesbank for ongoing supervision.
The Banking Act of 1961 transferred the supervision of credit institutions
to the newly created Federal Banking Supervisory Office, with the Bundesbank
remaining integrally involved in material supervision. The act took account
of the fact that the Bundesbank always has to be aware of the financial stand-
ing of its counterparties in monetary policy operations, and it recognized that
the supervisory process benefits from the Bundesbank’s insights into the
money, capital and foreign exchange markets as well as the payment system.
It also recognized that the Bundesbank could use its network of branches for
on-site supervisory purposes, obviating the need for the supervisory agency
to build up its own local infrastructure.
The creation of the integrated regulator the Federal Financial Supervisory
Authority (BaFin) in May 2002 was a response to the cross-sectoral integra-
tion of financial institutions and markets and the increasingly blurred divid-
ing lines between products and marketing channels. BaFin is an agency under
public law, under the jurisdiction of the Ministry of Finance. In accordance
with the Banking Act and other special legislation, it is the central body for
supervising banks, insurance companies, investment firms and the securities
market. While subject to the control of the Ministry of Finance, BaFin is inde-
pendent in functional and organizational terms. Its independence is under-
pinned by its funding scheme, according to which its operations are financed
entirely by levies from the supervised institutions.
100
GERMANY
101
CASE STUDIES AND CROSS-COUNTRY REVIEWS
variables, especially regulatory capital. This raises new challenges for supervi-
sors assessing capital adequacy.
Monitoring of credit business. To contain risks, the Banking Act limits sin-
gle large exposures to the same borrower to 25 percent of liable capital or own
funds. Aggregate large exposures must not exceed 800 percent of liable capi-
tal or own funds.
The monitoring of exposures of €1.5 million or more is an additional
prudential instrument for both banking supervisors and lending institutions.
Credit institutions, insurance companies and financial services providers have
to report loans of €1.5 million or more to a Bundesbank credit register. The
Bundesbank adds up the reported loans for each borrower and informs the
lending institutions of their borrowers’ aggregate indebtedness and the num-
ber of lending institutions involved. Institutions required to submit such
reports may inquire about the level of indebtedness of a potential borrower
before they grant a loan that is subject to the reporting requirements, provided
that the potential borrower consents to such an inquiry. In early 2003 all cen-
tral banks in the European Union that operate a credit register signed a mem-
orandum of understanding setting out principles for an exchange of
information obtained from these supervisory instruments.6
102
GERMANY
103
CASE STUDIES AND CROSS-COUNTRY REVIEWS
104
GERMANY
105
CASE STUDIES AND CROSS-COUNTRY REVIEWS
B OX 2
By the mid-1970s the Deutsche mark had become the world’s second-
most important reserve and investment currency. This by-product of
Germany’s economic and monetary success relied partly on strongly expand-
ing “offshore” markets. In the 1980s, when many other developed countries
deregulated and liberalized their financial systems, the globalization of mar-
kets and enhanced competition among national financial industries caused
the German authorities to launch an ongoing reform process. These initia-
tives helped strengthen the capital market orientation of the financial sys-
tem and bolstered Germany’s role as an international financial center.
The reform process started in the mid-1980s (see annex B). Among the
first steps was the opening of the market to floating-rate bonds and certificates
of deposit. Subsequent amendments to the Stock Exchange Act facilitated
equity financing and created the legal basis for establishing a financial futures
exchange. Since 1990 four Financial Market Promotion Acts have been
adopted to bring the operating framework of the capital market more in line
with evolving international standards. As a corollary to deregulation, measures
106
GERMANY
107
CASE STUDIES AND CROSS-COUNTRY REVIEWS
108
GERMANY
109
CASE STUDIES AND CROSS-COUNTRY REVIEWS
110
GERMANY
111
CASE STUDIES AND CROSS-COUNTRY REVIEWS
112
GERMANY
A NNEX A
M AJOR REPORTING REQUIREMENTS IN BANKING SUPERVISION
Information required Frequency
Liquidity Monthly
Liquid funds available
Liquidity ratios
Short-term information on selected positions of accounts Monthly
Assets
Expenditures and revenues
Balance sheet/income statement Annually
Assets and liabilities
Expenditures and revenues
Expenditure data collected by external auditors
(for example, data on nonperforming loans)
Adequacy of own funds of domestically active banks Monthly
Provision with own funds
Risk assets
Market risk position
Capitalization of internationally active banks Quarterly
Components of capital
Risk assets
Market risk positions
Capital ratio
Details of risk assets Quarterly
Calculation of risk positions
Balance sheet assets, off–balance sheet positions
Collateralized assets
Swaps, futures and options
Details of market risks and risk management Quarterly
Net equity position
Overall currency position
Settlement and counterparty risk positions
in the trading book
Options position
Commodities position
Net interest position
Institutions’ internal risk models
113
CASE STUDIES AND CROSS-COUNTRY REVIEWS
114
GERMANY
A NNEX B
C APITAL MARKET REFORMS , 1985–2002
Year Regulatory change
1985 Tax Revision Act
• Abolition of the “coupon tax” levied on nonresidents’ interest
income accruing from domestic bonds, thereby ending the
separation between the markets for Deutsche mark bonds issued
by domestic and foreign issuers (retroactive to August 1984).
Statement by the Deutsche Bundesbank of April 12
• Opening of the German market to new types of bonds, including
floating-rate notes and zero bonds.
1986 Revision of the minimum reserve regulations
• Authorization of the issuance of Deutsche mark–denominated
bonds having the characteristics of certificates of deposit.
1989 Amendment of the Stock Exchange Act
• Creation of a legal framework for electronic trading systems by, for
instance, abandoning the trading floor system.
• Liberalization of futures trading in securities and precious metals.
1990 First Financial Market Promotion Act
• Elimination of share stamp duty.
• Reduction of bill stamp duty and company tax.
• Enhancement of investment opportunities for mutual funds.
1994 Second Financial Market Promotion Act
• Establishment of the Federal Securities Supervisory Office.
• Ban on insider trading.
• Requirement that listed enterprises promptly disclose any
information that might affect their stock prices.
1998 Third Financial Market Promotion Act
• Comprehensive disclosure requirements for mutual funds
(prospectus, semi-annual reports).
• Mutual funds permitted to invest in futures contracts; new types
of funds permitted.
• Broadening of range of enterprises in which venture capital
companies may invest.
Act on Corporate Governance and Transparency
• Corporate governance improved by strengthening rules concerning
the composition of supervisory boards and the audits of annual
accounts.
115
CASE STUDIES AND CROSS-COUNTRY REVIEWS
116
GERMANY
A NNEX C
I NFRASTRUCTURE FOR THE TRADING , CLEARING , SAFE CUSTODY
AND SET TLEMENT OF SECURITIES
Under the aegis of Deutsche Börse AG, Germany has a consolidated system for
the trading, clearing, safe custody and settlement of securities. This highly
integrated network is efficient and safe, and its transactions costs compare
favorably with international standards.
Eurex Clearing AG, which belongs to Deutsche Börse Group, has created
a joint clearinghouse for trading financial futures, options and over-the-
counter issues and for Frankfurt spot trading in equities. Eurex Clearing AG
performs the role of a central counterparty in the clearing process, in which
buyers’ and sellers’ net positions (claims and liabilities with regard to the deliv-
ery of securities and the payment of the purchase price) are determined. It is
involved as a counterparty in the transactions negotiated between the two
trading parties and, in that capacity, settles the trades. The involvement of a
central counterparty with high financial standing reduces the settlement risk
for sellers and buyers and preserves the anonymity of the trade, including in
the posttrade process.
Clearstream Banking AG, which also belongs to Deutsche Börse Group,
is responsible for the safe custody of securities and the settlement of securi-
ties trades. Safe custody of securities is based on the following principles:
• Central securities depository: Clearstream Banking AG is the sole cen-
tral securities depository in Germany. Direct links between Clear-
stream and central securities depositories in other countries allow the
efficient cross-border transfer of securities held in collective custody.
• Collective safe custody: Securities, separated by type, are held in safe
custody in collective stocks at the central securities depository.
Without entailing any proprietary disadvantages for the customer,
individual ownership of a particular security is replaced by co-
ownership of the collective stock. This makes settlement consider-
ably easier, as certificates do not have to be moved physically in the
vaults of the central securities depository to reflect changes in indi-
vidual ownership. Instead, the securities remain in collective safe cus-
tody and changes in co-ownership are processed by book entries. The
procedure prevents processing bottlenecks from occurring in systems
based on physical delivery.
• Global certificates: As securities are not moved physically under col-
lective safe custody, the vast majority of securities issued in Germany
117
CASE STUDIES AND CROSS-COUNTRY REVIEWS
118
GERMANY
A NNEX D
C HRONOLO GY OF THE MOVE TOWARD CASHLESS PAYMENTS ,
1959–2001
Year Event
1959 Creation of a joint body of the banking industry associations and the
Bundesbank (the Working Party on Automation) in charge of
issues regarding the automation of payments.
1970 Introduction of standardized bank codes and payment forms.
1976 Introduction of paperless data media exchange service by magnetic
tape in interbank payments.
1977 Start of SWIFT cross-border payments.
1978 Start of electronic processing for individual credit transfers.
1979 Agreement between the banking industry associations and the Post
Office on the installation of cash dispensers and their cross-bank
availability for clients.
1981 Agreement of the banking industry on the introduction of point-of-
sale terminals in retail trade.
1982 Establishment of a central private institution for card processing and
check collection.
1983 Introduction of the eurocheck card with magnetic strip, permitting
access to cash dispensers.
1984 Agreement of the banking industry concerning the conversion of
paper-based credit transfers into data records and their processing.
Introduction of standard customer terms and conditions for home
banking orders.
1985 Agreement of the banking industry on a truncated check collection
procedure concerning checks not exceeding a certain limit (since
2002 the limit has been €3,000).
1987 Agreement of the banking industry on the conversion of paper-based
direct debits into records and their processing.
Establishment of a telecommunications network between Bundes-
bank computer centers for forwarding credit transfers and direct
debits submitted in paperless form by data media exchange.
1988 Introduction of telecommunications links between Bundesbank
branches for same-day processing of credit transfers.
1990 Introduction of a debit card procedure with a personal identification
number (PIN) and payment guarantee on a cross-bank basis for
cashless payment at automated cash registers.
119
CASE STUDIES AND CROSS-COUNTRY REVIEWS
120
GERMANY
N OTES
1. At the end of 2001 this ratio amounted to 391 percent for Germany and
395 percent for the United States.
2. The figure for Germany was revised upward after it was published in sev-
eral international publications. For the United States and Japan, see Group of Ten
(2001).
3. Under German law a pledge is an accessory security interest requiring an
underlying claim. The underlying claim may, however, be defined flexibly.
4. Where market prices do not apply, the collateral taker may seek satisfac-
tion through a public auction or, if a financial claim was pledged, by collecting
redemption and interest yields.
5. Minor restrictions exist for specific kinds of collateral that remain in the
debtor’s possession.
6. Involved are the central banks of Austria, Belgium, France, Germany, Italy,
Portugal and Spain.
7. The European System of Central Banks has established a procedure to
ensure that any official contribution to liquidity assistance does not have unde-
sirable implications for monetary policy.
8. The credit institutions’ obligation to hold balances of a given amount at
the central bank (the minimum reserve requirement) stabilizes the banking sys-
tem’s demand for central bank money. The requirement makes it easier for the
central bank (in this instance, the Eurosystem) to assess and provide liquidity to
the market.
R EFERENCE
Group of Ten. 2001. “Report on Consolidation in the Financial Sector.” January.
Basle.
121
I NDIA
India has a long history of financial intermediation. The first modern bank
in India was set up in 1770 by an agency house (box 1). The earliest attempt
to establish a central bank was in 1773, but it was short-lived. India was also
a forerunner in terms of development of financial markets. The Bombay
Stock Exchange was functional as early as 1870. The first life insurance com-
pany in the country, Oriental Life Insurance Company, was established in
1818, and the first general (nonlife) insurance company was set up in 1850.
By independence in 1947, India had a fairly well developed commercial
banking system. In 1951 there were 566 private commercial banks, with 4,151
branches, most in larger towns and cities. The Reserve Bank of India (RBI) was
originally established as a shareholder institution, like the Bank of England,
by a 1935 act promulgated by the government of India. The RBI then became
a state-owned institution in January 1949, when the Banking Regulation Act
provided a framework for regulating and supervising commercial banking
activity.
122
INDIA
B OX 1
Year Event
1770 Bank of Hindustan, the first bank in India on modern lines,
established.
1818 Oriental Life Insurance Company established.
1850 First general insurance company established.
1875 Bombay Stock Exchange starts formal trading.
1921 Three presidency banks, Bank of Bengal, Bank of Madras and
Bank of Bombay, merged into Imperial Bank.
1926 Hilton-Young Commission established to suggest a central
bank for the country.
1935 Reserve Bank of India (RBI) established as the central bank.
1947 Capital Issues Control Act imposed restrictions on issue of
capital.
1948 Industrial Finance Corporation, the first development finance
institution, established.
1955 Imperial Bank taken over by State Bank of India.
Industrial Credit and Investment Corporation of India estab-
lished.
1956 Life Insurance Company of India established.
Securities Contracts (Regulation) Act has a direct and indirect
impact on securities trading, running stock exchanges and
preventing undesirable transaction.
1962 Deposit Insurance Corporation established.
1963 New chapter inserted into 1934 RBI Act to effectively super-
vise, control and regulate deposit-taking activities of non-
bank financial companies.
1964 Industrial Development Bank of India established.
1966 Deposit insurance extended to cooperative banks.
1969 Fourteen largest commercial banks nationalized.
1973 General insurance companies nationalized.
Foreign Exchange Regulation Act was promulgated, provid-
ing an opportunity to develop Indian equity market.
1975 Regional rural banks established.
1980 Six more commercial banks nationalized.
1982 National Bank for Agriculture and Rural Development estab-
lished.
First credit rating agency established.
1990 Small Industries Development Bank of India established.
(continued on next page)
123
CASE STUDIES AND CROSS-COUNTRY REVIEWS
B OX 1 C ONTINUED
124
INDIA
initially sponsored by the RBI, to provide a channel for retail investors for
participating in the capital market. The Export Risk Insurance Corporation
was set up in July 1957 and was later converted into the Export Credit and
Guarantee Corporation in January 1964.
The RBI concentrated on regulating and developing appropriate mecha-
nisms and organizations for institution building. For instance, after serious
financial difficulties and the failure of several banks, including two relatively
large scheduled banks, the Deposit Insurance Corporation was set up in 1962
with a deposit insurance scheme.2
Despite the branch licensing policy of the 1960s, progress was modest: the
average population per bank office declined from 132,700 in 1950 to 64,000
in 1969. Although the share of credit to industry increased from 34 percent in
1951 to 67.5 percent in 1968, the agricultural sector got a little over 2 percent
of total bank credit. These features of bank credit were not consistent with the
goal of achieving equitable allocation of credit and the priorities set out in the
Five-Year Plans.
Even though the Indian banking system made considerable progress both
functionally and in terms of geographical coverage, many rural and semi-
urban areas were still not served by banks. And large industries and estab-
lished houses tended to enjoy a major portion of the credit facilities. To
diffuse banking facilities and change the pattern of bank lending, social con-
trol over banks, with organizational and legislative changes, was initiated by
the government. This transitory phase was followed by the nationalization of
banks.
In July 1969 the 14 largest commercial banks were nationalized to ensure
adequate credit flow to genuine productive areas in conformity with Five-Year
Plan priorities. Two significant aspects of nationalization were rapid branch
125
CASE STUDIES AND CROSS-COUNTRY REVIEWS
126
INDIA
127
CASE STUDIES AND CROSS-COUNTRY REVIEWS
128
INDIA
Competition
It is generally argued that competition enhances efficiency. In India, con-
certed efforts have been made toward the development of a multi-
institutional structure in the financial sector and the emphasis has been on
the increased efficiency of institutions through competition, irrespective of
ownership. Competition has been infused into the financial system princi-
pally through deregulation in interest rates, granting of functional auton-
omy to banks and allowing greater participation of private sector and foreign
banks (RBI 2000). New private sector banks have been granted licenses since
1993. Foreign banks have been granted more liberal entry. As part of the
deregulation process, there has been a significant easing of government con-
trol over the credit market. The statutory pre-emption of banks’ funds has
eased with the lowering of cash reserve ratio and statutory liquidity ratio. All
interest rates except savings deposit rates and nonresident external deposits
have been deregulated. New private sector banks had 12.5 percent of the assets
and 11.9 percent of the net profits of scheduled commercial banks (except
regional rural banks) as of end-March 2004. The respective shares of foreign
banks were 6.9 percent and 13.1 percent. The 2002/03 Union Budget
announced the intention to permit foreign banks, depending on their size,
strategies and objectives, to choose to operate either as branches of their over-
seas parent or as subsidiaries in India. In March 2004, the government of
India issued a notification that raised the permissible foreign direct invest-
ment limit in private banks to 74 percent, including the investment made by
foreign institutional investors. According to the government’s notification,
129
CASE STUDIES AND CROSS-COUNTRY REVIEWS
foreign banks are permitted to have only branches or wholly owned sub-
sidiaries. They may operate in India through one of the three channels:
branches, wholly owned subsidiaries or subsidiaries with aggregate foreign
investment up to a maximum of 74 percent in a private bank.
130
INDIA
tribunal. A set of guidelines has been issued to financial entities, so that the
process of instituting asset reconstruction companies proceeds on smooth
lines. Several institutions have initiated steps toward establishing asset recon-
struction companies. The RBI has given license to three asset reconstruction
companies, one of which has started functioning (RBI 2004b).
131
CASE STUDIES AND CROSS-COUNTRY REVIEWS
132
INDIA
133
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Insurance reforms
Insurance remained within the confines of the public sector until the late
1990s. The Insurance Regulation and Development Authority Act, 1999 ini-
tiated several changes, including allowing newer players and joint ventures to
undertake insurance business on risk-sharing and commission basis. Liberal-
ization of entry norms in the insurance segment has brought about a sea
change in product composition. Along with changing product profile, there
have also been salutary improvements in consumer service in recent years,
driven largely by new technology, better technical know-how from foreign
collaboration, focused product targeting to specific segments of the popula-
tion and cross-selling of products through bancassurance.
134
INDIA
transferee. Another important development under the reform process was the
opening of mutual funds to the private sector in 1993/94.
135
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Macroeconomic performance
During the first three decades after independence, the economy’s growth rate
hovered around 2.5–3.5 percent. The first signs of liberalization in the 1980s
propelled growth to 5.5 percent. The entire period was essentially marked by
a closed economy framework with limited opportunities for growth enhance-
ment, apart from domestic industrial activities. The opening of the economy
in the 1990s accelerated the growth levels close to 6 percent. There are two dis-
tinct phases evidenced in this case: the modest growth phase during the first
half of the 1990s, with a growth rate around 5.4 percent, and the higher growth
rate, around 6 percent, of the second half. Two features of this growth process
are notable. The growth in the 1990s, unlike that in the 1980s, was more broad-
based. And it was achieved under several different coalition governments.
The 1990s was remarkable because of its two phases of inflation: a high
inflation phase of around 10 percent during the first half of the decade and a
much lower level of around 6.8 percent during the second half. Inflation has
abated even further to around 4 percent in 2000/01–2002/03). The growth
enhancement in the open economy phase is more evident from the upward
movements of per capita income.
Another important dimension of the positive influence of an open econ-
omy approach can be judged from the strengthening of India’s external
account of the balance of payments. From a meager reserve position below
$1 billion in the early 1990s, India’s foreign exchange reserves have surpassed
$120 billion, indicating that India has emerged as a favored investment desti-
nation among emerging market economies.
136
INDIA
Table 1
was not uniform over the decades, and growth rates have been lower in the
1990s (table 1).
Recognizing the importance of strengthening institutions, prudential reg-
ulation and norms for income recognition and asset classification were intro-
duced in 1992 and strengthened in line with international best practices. A
strategy to gradually attain a capital to risk-weighted assets ratio of 8 percent
was put in place. With greater deepening of the financial sector in the 1990s,
the focus shifted to having tighter prudential norms, and the ratio was raised
to 9 percent in March 2000. As at end-March 2004, the ratio of the scheduled
137
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Cooperative banks
Over the last two decades, credit cooperatives have enjoyed very high growth.
Unlike commercial banks, asset quality of cooperative banks in recent years
does not indicate any discernable improvement, with an increase in nonper-
forming loans. The decreasing interest spread of cooperative banks indicate
that the gradual deregulation of scheduled urban cooperative banks has
resulted in more competition. This has not been witnessed in other segments
of cooperatives. A similar decline in operating expenses has also been
observed, driven primarily by a decline in wage costs.
138
Table 2
139
Total expenses 0.3 (2.6) 3.8 (5.5) 41.8 (7.2) 296.6 (9.1) 1,076.9 (9.7) 1,394.5 (9.1) 1,615.0 (8.2)
INDIA
Interest expenses 0.1 (0.9) 1.9 (2.8) 27.2 (4.7) 189.7 (5.8) 690.4 (6.2) 875.2 (5.7) 875.7 (4.4)
Establishment expenses 0.2 (1.3) 1.4 (2.1) 10.0 (1.7) 76.0 (2.3) 275.8 (2.5) 337.0 (2.2) 435.0 (2.2)
Profit 1.4 (1.2) 0.5 (0.7) 0.5 (0.1) 7.4 (0.2) 72.5 (0.7) 115.7 (0.8) 222.7 (1.1)
Net interest earning 0.3 (2.2) 1.7 (2.5) 10.4 (1.8) 85.5 (2.6) 301.4 (2.7) 394.5 (2.6) 564.6 (2.9)
Note: Figures in parentheses are ratios to total assets.
Source: Reserve Bank of India.
CASE STUDIES AND CROSS-COUNTRY REVIEWS
seriously eroded, especially in the second half of the 1990s, because of the dry-
ing up of concessional funds, downturn in the industrial sector, exposure to
traditional industries affected by restructuring and softening of interest rates.
Competition on the asset side has also become manifold, with banks entering
the domain of long-term finance. All these factors significantly impinged on
the profitability of development finance institutions.
Insurance companies
There are two broad indicators of the performance of the insurance industry:
penetration ratio and insurance density. Both indicators show India’s strong
international position among select emerging economies in the life insurance
industry compared with the nonlife insurance industry. In March 2003, there
were 12 private sector participants in life insurance business and 9 in nonlife
insurance. Most private companies in the Indian insurance sector have been
set up as joint ventures, with foreign partners holding up to 26 percent of the
total paid-up equity capital.4 The current profile of the Indian insurance
industry reflects that, notwithstanding the entry of private sector players, in
terms of both assets and liabilities, public insurance companies continue to
dominate.
Capital markets
The 1990s have been remarkable for the Indian equity market. It has grown
exponentially in resource mobilization, number of stock exchanges, number
of listed stocks, market capitalization, trading volumes, turnover and investor
base (table 3). It has witnessed a fundamental institutional change that dras-
tically reduced transaction costs and significantly improved efficiency, trans-
parency and safety. In the 1990s reform measures initiated by the Securities
and Exchange Board of India, market-determined allocation of resources,
rolling settlement, sophisticated risk management and derivatives trading have
greatly improved the framework and efficiency of trading and settlement.
140
Table 3
141
INDIA
Market capitalization
(billions of rupees) 12.0 27.0 68.0 1,102.8 11,926.3 7,492.5 6,319.2 12,012.0b
a. End of December values from the Stock Exchange, Mumbai only.
b. Data pertain to the Stock Exchange, Mumbai.
Source: The Stock Exchange, Mumbai and National Stock Exchange.
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Almost all equity settlements take place at the depository. As a result, the
Indian capital market has become qualitatively comparable to many devel-
oped and emerging markets.
Debt market
The central government’s reliance on market borrowings to meet its fiscal
deficit increased substantially during the 1990s, while dependence of state
governments did not. The combined net market borrowing of the central and
state governments during 2002/03 was 1,332 billion rupees compared with
106 billion rupees in 1990/91. Although in terms of the primary issues Indian
debt market is quite large, the government continues to be a large borrower.
Despite the increasing diversification of the debt market in terms of number
and variety of instruments available, government securities account for a
major portion of the debt market in India—in terms of outstanding stock,
market capitalization, trading volume and number of participants.
The corporate debt market is still nascent. Since the mid-1990s, private
placement has emerged as the most important component of the primary
issues market. The reason for rapid growth in the private placement market
lies in the convenience, flexibility and low cost of issuance as well as tailor-
made deals suited to both issuers and subscribers. The private placement mar-
ket is also preferred by corporates wishing to issue securities with complex or
nonstandard features.
142
INDIA
to outperform their public counterparts. This would imply a rise in their mar-
ket share along with the foreign bank group and accordingly, a concomitant
decline in the market share for public banks. The scope for this expansion
obviously depends on the expansion of the total banking system. As it stands,
the intermediation process has been taking place with the development of the
capital market. Public banks must decide how to adjust the loss of relative
market share in an environment where the absolute size of the pie is not
expanding rapidly. Moreover, the ability of different public banks to cope with
this challenge is likely to be different.
Another major concern for the banking system is high cost and low pro-
ductivity, reflected in high spreads and cost of intermediation. Both spreads and
operating costs, measured as a share of total bank assets have generally been
higher than those in developed countries. An important challenge for the bank-
ing sector, therefore, remains its transformation from a high-cost, low-
productivity structure to a more efficient, productive and competitive setup.
The capital requirement of banks is likely to increase in the coming years
with the pickup in demand for credit and the implementation of Basel II
norms around 2006, which accord greater emphasis on risk sensitivity in credit
allocation. Banks will need to increase their profitability to internally gener-
ate sufficient capital funds, because maintaining the additional capital posi-
tion in line with the prescribed norms could pose a major challenge.
Commercial banks continue to face the problem of the overhang of non-
performing loans, attributable to such systemic factors as weak debt recovery
mechanism, nonrealizability of collateral and poor credit appraisal techniques.
The recent enactment of the SARFAESI Act has increased the momentum for
the recovery of nonperforming loans. Banks need to intensify their efforts to
recover their overdues and prevent generation of new nonperforming loans.
The issue of corporate governance has recently gained prominence, more
so in view of the recent accounting irregularities in the United States. The qual-
ity of corporate governance will become critical as competition intensifies,
ownership is diversified and banks and cooperatives strive to retain their client
base. This will necessitate significant improvement in such areas as house-
keeping, audit practices, asset-liability management, systems management and
internal controls in order to ensure the healthy growth of the financial sector.
Before legislative reforms, nonbank financial companies mobilized a sig-
nificant portion of their funds as public deposits, often at high interest rates.
This, coupled with relaxed regulatory and supervisory arrangements, created
negative externalities including moral hazard. Introduction of reform
143
CASE STUDIES AND CROSS-COUNTRY REVIEWS
measures for nonbank financial companies has eliminated most of these prob-
lems, and the share of public deposits in the total liability of nonbank finan-
cial companies has substantially declined. Protection of depositor interests
still remains paramount, though. Toward this objective, the RBI continues to
pursue with various state governments the case for enacting legislation to pro-
tect depositor interest.
The entry of private sector players in the insurance sector has yet to make
a significant dent in the market share of the public entities. Recent evidence,
however, suggests that the state-of-the-art services provided by private play-
ers have begun to make an impact on the existing insurance industry.
Accordingly, promoting the role of competitive forces in the process of insur-
ance liberalization is essential, not only for customer choice, but also for rais-
ing resources for long-term infrastructure finance.
144
INDIA
risk-free yield curve and monetary policy transmission as well as global inte-
gration), establishing regulatory and supervisory standards (Board for
Financial Supervision) and insisting on greater transparency and disclosures.
It was only in the second stage that many legal amendments (the Securities
Contract Regulation Act, the Government Securities Bill, the SARFAESI Act)
and diversification of ownership of public banks were undertaken. The Indian
experience also shows that there is no optimal sequencing of policies or insti-
tutions, both within and across countries.
There is also no threshold level of institution building that should precede
capital market opening. They can happen simultaneously or in any sequence.
In the equity market many good institutional practices, such as clearing house,
settlement house and technological infrastructure for trading, came at a much
later stage of development. In the government securities market, good settle-
ment practices and institutions to develop primary and secondary markets
came in the early phase of reform. In fact, the RBI set up institutions to develop
the money and gilts markets and later divested the institutions that it owned
to avoid the moral hazard of the RBI acting as the lender of last resort. The
subsequent phase of institution building fostered transparent and efficient
market practices and helped in risk containment (such as the Negotiated
Dealing System, Clearing Corporation of India Ltd., primary dealers and the
screen-based system for trade in gilts).
The role of technology is critical for institution building because it
increases efficiency by globalizing the market. Technology reduces the time
and cost required to implement initiatives that strengthen the financial sector.
Setting up automated teller machines has increased people’s access to banks.
In the financial markets, technology has been harnessed to increase trans-
parency (Negotiated Dealing System), reduce risk in settlement (Clearing
Corporation of India Ltd), enable price discovery through screen-based auc-
tions and hedge market risks through screen-based trading systems for deriv-
atives. In the equity and debt markets, depositories eliminated the operational
vulnerabilities associated with physical certificates. These changes added up to
a complete transformation of market design accompanied by a corresponding
transformation of human capital in the financial services industry.
It is critical that reforms balance efficiency with stability, especially in an
emerging market economy like India. Greater competition modifies the effec-
tiveness of existing institutions. It improves efficiency, increases incentives for
innovation and promotes wider access. There is, therefore, a need to modify
existing institutions to complement new and better institutions. Effective
145
CASE STUDIES AND CROSS-COUNTRY REVIEWS
C ONCLUSION
Reform efforts in terms of strengthening prudential norms, enhancing trans-
parency standards and positioning best management practices are an ongo-
ing process. Efforts are also focused on increasing efficiency and productivity
within an overall framework of financial stability. Organized banking has
made its presence felt in remote parts of the country. Insurance, so far a pub-
lic monopoly, has since been transformed into a competitive market in both
life and nonlife segments. Strengthening corporate governance in coopera-
tive banks has been making progress. Disclosure standards have been strength-
ened for nonbank financial companies. Development finance institutions are
also restructuring in an era of global competition. Many reforms have been
undertaken in most areas of financial sector, reflected in the growing sophis-
tication of the financial system. The resilience of the system is reflected in the
absence of a major crisis, a sustainable and broad-based growth environment,
lower levels of inflation and a strong external sector. No doubt, the institu-
tional framework of the financial sector had a major role in this process, and
globalization in the financial sector has been beneficial for the economy. At the
same time, the stance of the authorities has been proactive, reacting to the
macroeconomic policy stance, global challenges and constantly endeavoring
toward international best practices.
N OTES
1. The definition of a small industry has undergone a transformation over the
years. In 1960, a small industry was defined as one with gross value of fixed assets
146
INDIA
not exceeding Rs.500,000. This figure has been gradually revised upward and
presently stands at Rs.10 million.
2. The Deposit Insurance Corporation was established by an act of Parliament
on 1 January 1962. With effect from 15 July 1978, it took over the work of the
Credit Guarantee Corporation of India Limited, a public limited company pro-
moted by the RBI on 14 January 1971, and it was called the Deposit Insurance and
Credit Guarantee Corporation. The objective was to integrate the twin and related
functions of giving insurance protection to small depositors in banks and provid-
ing guarantee cover to credit facilities extended to certain categories of small bor-
rowers particularly those belonging to the weaker sections of the society.
3. Nonbank financial institutions are a set of institutions catering to diverse
investor needs such as hire purchase, equipment leasing and making loans and
investments. Their major differences with banks are that they are prohibited from
issuing chequeable deposits and that they have limited fixed assets and less
regulation.
4. Under the current norms, the maximum limit on foreign participation in
the insurance companies operating in India is 26 percent.
R EFERENCES
India. 1991. “Report of the Committee on the Financial System.” Reserve Bank
of India, Mumbai.
———. 1998. “Report of the Committee on Banking Sector Reforms.” New Delhi.
Insurance Regulatory and Development Authority. 2002. Annual Report 2001–02.
New Delhi.
National Stock Exchange of India Limited. 2002. Indian Securities Market: A
Review. Vol. V. Mumbai.
RBI (Reserve Bank of India). 2000. “Report on Currency and Finance,
1999–2000.” Ahmedabad.
———. 2003. “Report on Trend and Progress of Banking in India, 2002–03.”
Ahmedabad.
———. 2004a. “Globalisation: The Role of Institution Building in the Financial
Sector: The Indian Case.” RBI Bulletin, February.
———. 2004b. “Report on Trend and Progress of Banking in India, 2003–04.”
Ahmedabad.
Reddy, Y.V. 1998. “Financial Sector Reform: Review and Prospects.” RBI Bulletin,
December.
World Bank. 2001. World Development Report 2002: Building Institutions for
Markets. New York: Oxford University Press.
147
I NDONESIA
Globalization has become a common theme around the world since the early
1980s. Its main impetus has been the greater integration of global financial
markets, supported by the abolition of capital controls and the drastic decrease
in transaction costs thanks to new communication and information tech-
nologies. This financial globalization, combined with good macroeconomic
policies and good domestic governance, appears to be conducive for economic
growth.
Nevertheless, despite the broader opportunities that globalization brings
for rapid economic growth, the distribution of benefits across countries
remains an open issue. Recent financial crises have shown that globalization,
especially when it relates to the integration of domestic financial markets into
a global market, provides both opportunities and challenges. The new capital
flows can magnify economic booms as well as deepen economic crises, with
destabilizing effects on an emerging economy.
The main factors behind the recent financial crisis in Asia, particularly in
Indonesia, are weak institutional and regulatory infrastructures. To this end,
countries need strong institutions and viable regulatory frameworks to reap the
benefits of globalization. Bearing in mind the beneficial aspects of globaliza-
tion, the Indonesian authorities believe that the country cannot isolate itself
from the global trend toward market integration. This has been increasingly
reflected in policies and deregulation measures, especially since the early 1980s.
B ANKING REFORM
Banking reform during the pre-crisis period was driven by domestic needs,
while the post-crisis reforms stemmed mainly from the need to adjust to pur-
sue globalization.
148
INDONESIA
149
CASE STUDIES AND CROSS-COUNTRY REVIEWS
150
INDONESIA
151
CASE STUDIES AND CROSS-COUNTRY REVIEWS
the banking system. Those policies include the introduction of the Govern-
ment Guarantee Scheme, establishment of the Indonesian Bank Restructuring
Agency (IBRA), recapitalization of banks, restructuring of the real sector and
improvement of banking infrastructure, corporate governance and banking
supervision.
To restore public confidence and avoid bank runs, starting 27 January
1998, the government introduced a full blanket guarantee on bank liabilities.
In addition, bank restructuring was integrated with corporate restructuring
to ensure that recapitalized banks were free from making loans to distressed
corporations. Three agencies—IBRA, the Indonesian Debt Restructuring
Agency and the Jakarta Initiative Task Force—were created to conduct cor-
porate restructuring. IBRA’s main responsibilities were to execute the opera-
tions of government blanket guarantee, to take over and rehabilitate ailing
banks and to manage the nonperforming assets of those banks. The recapi-
talization program, aimed at preserving the viability of banks having good
prospects, was implemented through ownership restructuring, which was to
be temporary and not intended to nationalize the particular banks in the long
term. In addition, Bank Indonesia instituted a special task force dealing with
loan restructuring and optimization, functioning as facilitator between
debtors and creditors. The facilitating activities involved providing debtor
information, arranging meeting between creditors and debtors, acting as
mediator and observer and providing technical assistance.
To finance the costs of bank recapitalization, the government had to issue
recapitalization bonds that banks held in their investment, trade and collateral
portfolios. These bonds consisted of variable and fixed-rate bonds, as well as
hedge bonds. At the end of December 2002 government recapitalization bonds
stood at Rp.429.4 trillion, with Rp.99.7 trillion (23.8 percent) in the trade port-
folio and Rp.319.6 trillion (76.2 percent) held in the investment portfolio.
In sum, the source of the crisis was the fact that Indonesia’s economic
integration with the world economy was not supported by well developed
institutions, the prerequisites for an efficient market economy.
152
INDONESIA
stability, a stabilized rupiah and a relatively low interest rate, activities in the
capital, bond and multifinance markets were ignited in 2003, with the stock
market capitalization reaching Rp.346 trillion ($40 billion) by July. Notwith-
standing, nonbank financial institutions in Indonesia remained relatively
undeveloped.
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
begun. The establishment of this market, and especially its size, will facilitate
the development of other markets and provide market players with longer
maturity options. With declining interest rates, mutual funds have begun to
take advantage of this new bond market and are growing rapidly.
Insurance firms, pension funds and finance companies have also been
subject to increasing reform, liberalization and regulatory policy change. For
example an insurance law and supporting regulations were put in place in
1992. These established the licensing, procedures and business conduct rules
for insurance and reinsurance companies. The rules allowed 80 percent for-
eign ownership and the establishment of numerous international insurance
companies. More recently, regulatory changes have mandated changed sol-
vency requirements. Post-crisis domestic insurance partners have had diffi-
culty raising capital, and the government has relaxed the rules on foreign
ownership. Most recently, the insurance regulator has put risk-based capital
measures and know-your-customer regulations in place.
Employer-sponsored and financial institution pension funds are designed
to supplement basic pension benefits provided through a mandatory provi-
dent fund (for the private sector).2 The development of the pension fund was
promoted with the passage of a law regulating pensions in 1992. In 1993 the
Social Security system was reformed with the implementation of the Employees
Social Security Act. Since then, ministerial decrees have set actuarial, audit and
reporting requirements, as well as regulations on investment, including limits
on the share of investment with any one investment institution.
154
INDONESIA
155
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Policy directions
Demand in the capital market will increase through improved market mech-
anisms, transparency on the part of listed firms and the introduction of new
products. The government’s overall objective is to improve information avail-
ability and reliability, legal certainty and operational efficiency. A key problem
is the number of brokers that do not actively trade but hold seats on the mutu-
alized bourse. The immediate policy agenda is to increase the amount of paid-
in capital and to demutualize the bourse. This should consolidate the number
of securities firms and improve incentives.
The authorities are also working to revise regulations to improve audit
and disclosure for listed companies as part of a broader program to improve
corporate governance. Due to their recent rapid growth, mutual funds are a
particular priority. To meet more sophisticated consumer demand, there will
also be a focus on developing new capital market products, including futures,
options, asset-backed securities and Syariah products.
Meanwhile, the insurance industry faces some similar issues, including
insufficiently capitalized firms. An amendment to the insurance law is being
proposed that will increase capital requirements to supplement existing risk-
based capital measures. New audit procedures are being prepared to verify
insurance and reassurance firms. Fit-and-proper tests will be instituted, and an
insurance guarantee institution created. Ministerial decrees will be brought in
line with international best practice or core principles. A key problem is the lack
of investment vehicles that allow an appropriate match of asset and liability
maturities. Effective development in the capital market and the increased trad-
ing of government bonds should help insurance companies find new and bet-
ter uses for their capital.
In the pension fund market, the role of the Indonesian provident fund,
Jamsostek, is under review. But the current system that provides basic pension
(and other social) services with private sector employer (or financial sector)
supplementary programs will be continued. The government is committed to
improving the training and certification of pension fund managers, including
continuing education, revised rules on pension fund investment, improved
governance and transparency in reporting. Again, improvements in the over-
all capital markets are critical to allow pension funds investment vehicles with
appropriate diversity and maturity structures. In particular the government
will move to encourage pension funds to reduce their dependence on bank
deposits. In return there will be an equal emphasis on encouraging firms listed
on the stock market to add supplementary pension funds for their employees.
156
INDONESIA
Deposit insurance
In an effort to maintain the stability and resilience of the national banking sys-
tem, a mechanism needs to be created to maintain public confidence in the
banking system. One of the supporting instruments will be the availability of
a financial safety net, which can provide assurance about the protection of
customer funds if a bank fails to fulfill its obligations. The lack of an explicit
guarantee on public saving funds was one factor causing the bank run after
the closing of 16 banks in November 1997. To stabilize the situation, the gov-
ernment provided a blanket guarantee. Within a relatively short time, public
funds flowed back into the banking systems, and total public savings have now
reached approximately 70 percent of total bank assets. But behind this success
is the large burden that has to be borne by the government and the potential
moral hazard in the banking sector. To rectify this, it would help to formulate
a more effective guarantee of customer savings. A limited guarantee, such as
deposit insurance, is one alternative.
A working team (comprising representatives from Bank Indonesia, the
Ministry of Finance and IBRA) had been appointed with the task of prepar-
ing for the establishment of the deposit insurance institution (LPS). The short-
term agenda is to formulate a phasing out for the guarantee coverage on almost
all bank obligations; it would be limited to savings, collections, incoming and
outgoing transfers, interbank lending and letters of credit. The long-term
agenda is to make preparations for the establishment of a deposit insurance
institution, using an insurance scheme with limited guarantee coverage.
Several criteria for the deposit insurance institution need to be deter-
mined, including institutional status, premiums and membership. To enable
LPS to execute its tasks effectively, there needs to be a guarantee of indepen-
dence in executing its tasks and authority. It is expected that the LPS would
be a legal entity outside the government, accountable directly to the parlia-
ment. Membership in the LPS will be compulsory for all banks operating in
Indonesia, including foreign banks, to ensure equal business opportunities. It
was expected that a period of three years from 2001 would be sufficient for
making preparations for the establishment of this institution, so 2004 should
be the right time to start applying guarantees based on LPS.
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
158
INDONESIA
159
CASE STUDIES AND CROSS-COUNTRY REVIEWS
L ESSONS
Indonesia’s economic integration into the world economy has taught us valu-
able lessons to improve our economy’s efficiency and resilience in the future.
Several lessons have emerged from globalization:
• First, though it is undeniable that globalization bestows prosperity to
the economy and creates modern economic states, a clear lesson is
that some countries, particularly developing countries, cannot fully
reap the benefit without strong financial infrastructures.
• Second, the reason that Indonesia’s economic integration into the
world economy could not be fully enjoyed was because it is not sup-
ported by well developed institutions, including well regulated finan-
cial institutions as prerequisites for an efficient market economy.
160
INDONESIA
161
CASE STUDIES AND CROSS-COUNTRY REVIEWS
C ONCLUSION
Before the crisis, liberalization in Indonesia’s financial sector, particularly in
banking, was driven by domestic needs. After the crisis, reforms stemmed
mainly from the integration of Indonesia’s economy in the world market.
The Indonesian experience in and after the crisis and the challenge of eco-
nomic globalization has motivated the government to focus on the institu-
tional foundations of the financial system. The key effort is to develop a
comprehensive financial safety net by forming a Financial Service Authority
and a Deposit Insurance Company. This financial safety net is one of three
key government priorities for the next year as it moves to establish a safer and
sounder national financial system. An integrated, efficient and effective finan-
cial safety net would provide clear lines of authority and responsibility among
the major financial oversight institutions. The Ministry of Finance is the fis-
cal authority, Bank Indonesia the monetary authority, the Financial Service
Authority a comprehensive financial service regulator and supervisor and
the Deposit Insurance Company the guarantor of bank depositors.
From the monetary side, the central bank has a key role in developing
and implementing adequate prudential regulations, in supervising of finan-
cial institutions and in maintaining close coordination and collaboration with
the supervisory agencies. To ensure that the banking sector benefits more
strongly from globalization, the central bank needs to build sound institu-
tions and policies that support and complement the expansion of the bank-
ing sector.
The government is committed to expanding the role of the capital mar-
ket by providing financing to improve maturity and risk profiles. It is increas-
ing demand for equities and bonds by improving the market mechanism,
increasing the transparency of listed firms and promoting new products. It is
also eliminating inactive securities companies by increasing the amount of
paid in capital and demutualizing the bourse. Also in progress are revisions
of regulations to improve audit and disclosure rules for listed companies—as
part of broader program to improve corporate governance.
162
INDONESIA
A key problem facing our rapidly growing insurance and pension indus-
tries is a lack of investment vehicles that allow appropriate matches of asset and
liability maturities. This should be improved by the development of the capi-
tal market and the increased trading of government bonds. Promoting con-
solidation and raising the capacity of practitioners and regulators will create a
healthier and more competitive enviroment as regional integration proceeds.
With such a commitment to creating a strong comprehensive foundation
for the national financial system, Indonesia would be able to compete in finan-
cial globalization. Still aware of the consequences of missteps and faulty
sequencing, it will monitor reforms and integration continously—in princi-
ple, to work with globalization, not against it.
N OTES
1. Finance companies are not permitted to take deposits, but they are allowed
to undertake leasing, factoring, credit cards and consumer finance.
2. Government employees have their own system.
R EFERENCES
Bank of Indonesia. Various years. Annual Report. Jakarta.
Daly, Herman E. 1999. “Globalization versus Internationalization: Some Impli-
cations.” Global Policy Forum, New York. [http://globalpolicy.igc.org/
globaliz/econ/herman2.htm].
IMF (International Monetary Fund). 2000. “Globalization: Threat or Opportu-
nity?” Washington, D.C.
Indonesia, Ministry of Finance, Directorate of Insurance. “Indonesian Insurance
Industry in 2001.” Jakarta.
Indonesia, Ministry of Finance, Directorate of Pension Fund. “2001 Annual
Report of Pension Fund.” Jakarta.
Indonesian Capital Market Supervisory Agency. 2002. Annual Report 2002.
Jakarta.
Jakarta Stock Exchange. Various years. “Statistics.” Jakarta.
Kartasasmita, Ginandjar. 2001. “Globalization and the Economic Crisis: the
Indonesian Story.” WCFIA Working Paper 01-03. Harvard University,
Waterhead Center for International Affairs, Cambridge, Mass.
Nigon, John, and Chris Amedeo. “Pros and Cons of Globalization.” ECON 4999.
Ouattara, Alassane. 1998. “Globalization, Lessons from the Asian Crisis and
Central Bank Policies.” Remarks at the Réunion des Gouverneurs des
Banques Centrales des Pays Francophones, 23 June, Ottawa.
163
CASE STUDIES AND CROSS-COUNTRY REVIEWS
164
I TALY
Over the last 25 years, legislation, taxation, supervision and the promotion of
competition have combined with domestic economic developments and inter-
national trends to make far-reaching changes in the Italian financial system.
Apart from underdeveloped pension funds, a serious deficiency, the structure
of the Italian system is similar to those on the international stage.1
The Italian financial industry has modernized its operations and perfor-
mance. It has become more market-oriented and somewhat less reliant on
relationship-based financial intermediation and institutions. It has advanced
in the quantity, productivity and prices of banking services and in the diver-
sification, depth and efficiency of markets. Financial integration has opened
domestic intermediaries to foreign competition. A sound legal, regulatory and
monitoring infrastructure has been gradually built, maintained and adapted
to the evolving needs of market processes and participants. Such changes
depend only in part on the forces that have shaped the changes in European
finance: worldwide financial integration, financial innovation and the unifi-
cation of monetary policy in the euro area.
The weakness of the Italian financial industry still lies in fairly high labor
costs, even though the gap with its main partners has been significantly
reduced in recent years. The distribution, quality and scope of some services
also leave room for improvement. But that improvement cannot be entirely
decoupled from the propensity of Italian companies and households to
demand more sophisticated financial products and services. Habit formation
and catching up along the learning curve of financial innovation may stand
in the way of taking full advantage of the potential and new opportunities. The
current phase of technological innovation, its pace and magnitude require
complex financial solutions, which often include “arm’s length” fundraising
and products intermediated by financial markets. Yet small and medium-size
enterprises, the bulk of the Italian private sector, may still find instruments
entailing stock market listing (or intensive information disclosure and com-
pliance) too costly for their needs.
The financial sector can contribute to the Italian economy’s return to
growth. But its contribution will depend not so much on further public pol-
icy measures, but on the behavior of relevant market players. The actions of
bankers and financiers will be important in lowering labor costs and upgrad-
ing the quality of services in today’s competitive environment. Results will
also depend on the willingness of households and firms to make full use of
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
instruments that the financial system now offers—which they have failed to
do so far—and of instruments the system will supply in the future, in line
with the trends in international and European finance.
166
ITALY
distinction between banks and special credit institutions and the different
categories of institutions. An important consequence: greater competition
among former short-term banks and former special credit institutions.
Participation in the capital of banks continued to be regulated in accord with
the principle of separating banking and commerce.
Although the concentration of bank market shares increased at the
national level, the number of banks operating in each Italian province (which
can be thought of as local markets) increased strongly, and the spread between
lending and deposit rates narrowed significantly (Ciocca 1998). Deregulation
progressed further with the privatization of the banking sector, and consoli-
dation accelerated, with the number of banks falling by a third. A new law on
financial intermediation set out the conditions for more efficient provision of
financial services. And new corporate governance rules ensured better pro-
tection of minority shareholders.4 These changes affected the structure of the
financial system.
The traditional importance of intermediaries, both on the asset and the
liability side, permitted researchers to classify the Italian financial system as
intermediation oriented.5 Until the 1970s, banks dominated the allocation of
financing, evidenced in the high value of the ratio of banks’ financial activi-
ties to total financial activities. Household assets were largely invested in
deposits. On the liability side of the nonfinancial sectors, bank loans were the
main source of finance. Because of controls on exchange rates and tight reg-
ulation of financial investments abroad, assets held with the rest of the world
were very limited. A first wave of disintermediation in the banking sector took
place in the 1980s with a growing market in government securities. On the
asset side, deposits in investors’ portfolios declined, paralleled by an increase
in public sector securities directly held by households. But high inflation lim-
ited those investments to short-term maturities.
In the 1990s the reductions in inflation and government deficits, coupled
with the effects of the liberalization measures implemented at the end of the
1980s, fostered more reallocations of financial wealth to market instruments.
The process was accelerated by the European Monetary Union, which con-
tributed to the decrease in inflation as well as in nominal and real interest
rates. The adjustment of public finance implied a reduction in the supply of
government securities relative to GDP and prompted the redirection of house-
hold wealth toward shares and mutual funds. The rise in the proportion of
shares in household portfolios was further accelerated by the privatization of
state-owned firms and public sector utilities.
167
CASE STUDIES AND CROSS-COUNTRY REVIEWS
168
ITALY
1995) and the ability of the private sector to absorb massive new gross issues
of public debt (amounting to 50 percent of GDP a year) and the shedding of
government securities by the banking system. That system, including the cen-
tral bank, reduced its holdings from 60 percent of the stock outstanding in
1980 to less than 20 percent in the 1990s. Foreign investors, who had been
virtually absent from this market, today hold almost a half of Italy’s public
debt. A decisive factor was the creation in 1988 of an efficient screen-based
market in government securities (MTS) by the main domestic participants at
the behest of the Treasury and the Bank of Italy.
The growth of the private capital market has been less vigorous. The cap-
italization of the Milan stock exchange evaluated in 2000 was comparable to
that of the Frankfurt exchange (70 percent of GDP), but lower than the fig-
ures for Paris (97 percent), New York (178 percent) and London (191 per-
cent).7 The global downturn in share prices that began in 2000 shrunk Italian
stock market capitalization to 37.5 percent of GDP at the end of 2003; this fig-
ure was equal to 40.1 percent in Germany, 69.3 percent in France, 123.6 per-
cent in the United Kingdom and 129.9 percent in the United States.
The institutional and organizational turning point for the Italian stock
exchange is recent, but the changes have been radical. Ownership of all the
markets for the trading of corporate and government securities was priva-
tized between 1996 and 1999, after nearly half a century of having the mar-
kets instituted, managed and supervised within the framework of public law.
Companies limited by shares have been charged with managing market struc-
tures and endowed with self-regulatory powers over the admission, exclusion
and suspension of financial instruments and market participants, the rules
for trading and the dissemination of information on trading. The procedures
for exercising these powers are laid down in rules adopted by the market man-
agement companies and approved by the authorities.
Italy also now has a large and efficient money market today for trading in
short-term government securities and interbank funds (E-MID). An integral
part of the euro market, indeed one of its most advanced components, the
money market enables Italian banks to vie with other European banks in their
Treasury management. Monetary policy was strengthened with the introduction
of repos (1979) and changes in the classical refinancing instruments, including
the revision of the penalty rates on fixed-term advances (1991) and the intro-
duction of a commission on overdraft facilities (1985). The transition from
administrative instruments and direct control—ceilings on the increase in bank
lending and securities investment requirements for banks—to market-based,
169
CASE STUDIES AND CROSS-COUNTRY REVIEWS
170
ITALY
The fall in inflation and nominal interest rates from the early 1980s, together
with high real yields and rising rates of profit, was a contributory factor.8 These
developments were sanctioned by the 1993 Banking Law and the 1998 Single
Act on Financial Intermediation, which provide for an extended taxonomy of
financial services that can be further expanded by contractual autonomy, in
accordance with Article 1322 of the Civil Code.
The universe of financial undertakings has been simplified with despe-
cialization in the banking industry, which now counts 788 banks with 30,500
branches, and enriched in both number and types of nonbanks (table 1). On
the organizational front, the intermediate solution of the multifunction group
Table 1
171
CASE STUDIES AND CROSS-COUNTRY REVIEWS
172
ITALY
Table 2
in Europe. The figure is 15 percent today, one of the lowest in Europe, and will
decline further with the residual disposals to be carried out by the bank foun-
dations. The privatization of the public sector banks was concentrated in the
space of a few years, but its institutional gestation was long and complex. The
reform passed through three phases: the alignment of the rules applying to
banks in the public sector with those governing banks in the private sector, the
transformation of public sector banks into companies limited by shares and
the elimination of the restrictions on the ownership of the capital of the for-
mer public sector banks.
On the basis of holdings in excess of 5 percent of the capital reported to
the Bank of Italy in 1998, 27 percent of the capital of Italian banks is owned
by other Italian banks, 4 percent by foreign banks, 18 percent by public and
nonprofit institutions and 5 percent by insurance companies and financial
173
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Table 3
undertakings (holdings of less than 5 percent account for the rest). In their
shares in total bank intermediation, banks are 63 percent controlled by other
Italian banks, 15 percent by foundations and public bodies, 5 percent by insur-
ance, industrial and financial undertakings and 2.5 percent by foreign banks.
The problems of ownership structure in the banking system—hard cores,
shareholders’ agreements and cross-shareholdings—must also be evaluated
in the light of the huge scale of the privatization process and the short time
for carrying it out.
174
ITALY
for Italian and foreign nonbank capital movements. Total transactions in the
foreign exchange market have tripled to reach $30 billion a day.
The Italian banking system has not been closed to international relation-
ships since World War II, not even when capital exports by residents were dis-
couraged or prohibited and even subject to penal sanctions such as those laid
down by Law 159/1976. In the 1980s and even more in the 1990s, with the
removal of exchange controls, the international activity of Italian banks grew
in every respect, indicating an effective ability to be a competitive player in
financial globalization.9
As suggested in the academic literature, entry by foreign banks makes
domestic banking systems more efficient by reducing their margins.10 Barth
and others (2001, 2002) analyze various regulatory restrictions in place in
1999 (or around that time) on commercial banks, including various entry and
exit restrictions and practices. They find that tighter entry requirements are
negatively linked with bank efficiency, leading to higher interest rate margins
and overhead expenditures, while restricting foreign bank participation tends
to increase bank fragility. These results are consistent with the view that tighter
entry restrictions tend to limit competition and emphasize that it is not the
actual level of foreign presence or bank concentration, but the contestability
of a market that is positively linked with bank efficiency and stability.
The Italian banking system’s exposure to the emerging countries is about
$36 billion, equal to some 25 percent of its capital and reserves in 2003. The
amount is not inconsiderable, but the ratio to capital is the lowest among
Organisation for Economic Co-operation and Development (OECD) coun-
tries with advanced financial systems.
In 2000 the ratio of banks’ total assets to GDP was 153 percent in Italy (173
in 2003), against a euro area average of 255 percent. Four balance sheet com-
ponents were relatively underdeveloped for Italian banks compared with banks
in the other euro area countries: interbank activities, securities portfolio, for-
eign assets and loans to households.11 Interbank activities (loans to MFIs res-
ident in the euro area) represented 14 percent of total assets, compared with
21 percent for the euro area. The difference basically reflects the existence in
Italy from the beginning of the 1990s of an efficient screen-based market for
interbank deposits (E-MID), which led to a reduction in the number of bilat-
eral current accounts between banks.
The ratio between the overall amount of securities and shares with coun-
terparts in the euro area and total assets was one percentage point lower in Italy
than the euro area average (16 percent and 17 percent, respectively).12 The foreign
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
assets to total assets ratio was 5 percent, seven percentage points lower than the
euro area average. Loans to households represented slightly more than 13 per-
cent of total assets, compared with a euro area average of 18 percent. Loans to
the nonfinancial sector represented slightly more than 50 percent of total assets
and were equal to 81 percent of GDP in Italy (26 percentage points less than in
the euro area). This difference can be largely ascribed to loans to households,
equal to 20 percent of GDP, compared with 46 percent in the euro area.
Regarding the maturity structure, the share of medium- and long-term
loans of Italian banks is lower than in the other euro area countries. Short-
term loans to nonfinancial corporations represent 52 percent of banks’ total
assets. The proportion also remains high if loans with an original maturity of
less than five years are considered (73 percent in Italy, compared with 52 per-
cent in the euro area). The high share of short-term loans in assets of Italian
banks is mainly the result of past high inflation. A high proportion of short-
term loans may also constitute a monitoring device on borrowers in the pres-
ence of inefficiencies in the liquidation of projects in financial difficulty.13 In
2000 variable interest rate loans represented 63 percent of the total amount of
loans to the nonfinancial sectors.
On the liability side, Italian banks also have a larger share of short-term
instruments. Overnight deposits represented around 67 percent of total
deposits, compared with 31 percent in the euro area. Virtually all deposits (98
percent) have a short maturity (overnight, deposits redeemable at notice up to
three months, deposits with agreed maturity up to two years). The share of
bonds in total domestic funding (96 percent) is similar to the euro area average.
176
ITALY
177
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Managed savings
The share of Italian households’ financial assets entrusted to third parties for
management was negligible at the beginning of the 1980s. But asset managers
and institutional investors have grown appreciably since then, contributing to
strengthening the money and securities markets. In Italy, as elsewhere, they have
satisfied the needs of savers arising from the growth of financial wealth, the pos-
sibility of investment diversification for even modest portfolios and the larger
volume of transactions in a setting of volatile and technically complex markets.
The birth of investment funds and the spread of individual portfolio man-
agement services in the early 1980s were a decisive impetus. Financial wealth
under management (investment fund units, individual portfolio management
accounts, insurance policies and pension funds) rose from 10 percent of
households’ financial assets at the beginning of the 1990s to 32 percent in
2003 (table 4). This share remains lower than the average of some 38 percent
for the Group of Seven (G7) countries. The gap is largely attributable to the
social safety net provided by the public sector in Italy, and hence to the scant
role still played by pension funds.
Italy holds an intermediate position among the main euro area countries
in managed savings as a percentage of GDP: over 71 percent at the end of
2003, compared with 64 percent in Germany and Spain and just over 72 per-
cent in France.15 A chasm remains with the United Kingdom and the United
States, where professionally managed savings are close to 125 percent of GDP.
In both countries the combined contribution of insurance companies and
pension funds is preponderant, amounting to some 100 percent of GDP in the
178
Table 4
Assets of institutional investors held by households in the main euro area countries and the United States,
1999–2003
End of period data (percent)
179
Total 33.3 30.5 31.5 41.1 30.8 38.0 36.1 42.3 31.9
ITALY
As a share of GDP
Investment fundsb 43.8 20.3 18.3 40.1 26.5 17.2 20.1 34.5 27.4
Insurance companies 14.4 50.9 35.3 25.1 20.3 54.9 40.1 26.3 23.1
Pension funds 2.0 — 3.4 69.9 2.1 — 3.6 53.6 2.2
Other institutionsc 18.0 — — 11.5 19.1 — — 8.0 18.5
Total 78.2 71.2 57.0 146.6 68.0 72.1 63.8 122.4 71.2
— Not available.
a. Preliminary.
b. Includes foreign funds.
c. For Italy, individually managed portfolios net of investments in investment fund units; includes the portfolios of institutional sectors other than households.
Source: Based on Eurostat, OECD, Bundesbank and Federal Reserve data.
CASE STUDIES AND CROSS-COUNTRY REVIEWS
United Kingdom and almost 80 percent in the United States, compared with
just over 25 percent in Italy. In France and Germany the market share of insur-
ance companies (but not that of pension funds) is large, accounting for more
than half of managed savings.
Derivatives
Among the most important of the financial instruments recently been intro-
duced or used more widely in Italy are derivatives, which have surpassed the
traditional techniques of risk management and risk allocation both in conve-
nience and in cost.
The Italian Futures Market (MIF), the first organized Italian market in
financial derivatives, was created in 1991. It is a screen-based market for finan-
cial futures and options contracts on Italian government securities and futures
contracts on short-term interest rates. With the privatization of the financial
markets in 1998, MIF was purchased by Borsa Italiana.
An Italian market in futures contracts on shares (Italian Derivatives
Market, IDEM) was constituted at the end of 1994 as an integral part of the
Stock Exchange. The creation of an options market sharply reduced the busi-
ness in traditional options (mercato dei premi), which had been traded on the
public stock exchanges since 1913. Negligible in Italy at the end of the 1980s,
the use of these instruments expanded rapidly thereafter. Unstable macro-
economic conditions, floating exchange rates following the crisis of the
European Monetary System in 1992 and uncertainty over interest rate con-
vergence within the European Monetary Union hastened the learning process.
In 1998 the average daily turnover in lira-denominated derivatives in
organized markets was more than $35 billion, two-thirds of it in the money
and bond markets. The latter component—nine-tenths of the trading is done
in London—contributed significantly to the formation of the euro area’s
derivatives market.16 It accounts for 15 percent of all the area’s transactions in
interest rate and bond derivatives. The size of the European market is now sig-
nificant, on par with that of the United States.
In 1998 trading in stock index derivatives on the Italian exchange
accounted for 15 percent of all such trading in European markets, a larger
share than in London and Paris and exceeded only by the German-Swiss Eurex
exchange. The information on over-the-counter trading is fragmentary, with
data gathered only from leading players. Italy’s share of the European market,
though significant, is smaller than its share of trading in organized markets.17
Like the foreign exchange market, the derivatives market is dominated by
180
ITALY
181
CASE STUDIES AND CROSS-COUNTRY REVIEWS
MTS MOTa
6,000 180
MOT
5,000 150
4,000 120
3,000 90
MTS
2,000 60
1,000 30
0 0
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
a. From 1999 MOT and Euromoney.
Source: National statistics.
almost half the overall turnover in the secondary market for Italian government
securities (for both outright transactions and repo contracts).
Borsa Italiana, the company managing the Milan-based Italian Stock
Exchange, also operates a screen-based retail market (MOT) for domestic fixed-
income instruments, and another screen-based market (EuroMOT) for euro
bonds, foreign bonds and asset-backed securities.
The need to provide market agents with appropriate risk-hedging tools
gave rise in 1992 to a market for government bond futures (MIF) and options
(MTO). Despite a fast start, both segments were outpaced by other European
markets, especially LIFFE (for short-term instruments) and more recently
Eurex (for long-term instruments) (table 5).
182
Table 5
183
ITALY
Table 6
184
ITALY
185
CASE STUDIES AND CROSS-COUNTRY REVIEWS
In the run-up to its peak, in the period 1998–2000, the MIB index (the index
of all shares listed on the Italian Stock Exchange) gained more than 81 percent,
compared with the 52.6 percent rise in the Dow Jones Euro STOXX index (fig-
ure 2). The higher return on Italian shares over the period is mainly attribut-
able to the shares of banks (which benefited from the restructuring and
consolidation of the banking sector in the second half of the 1990s) and to
those of telecom companies.
350
300
United States
(Standard & Poor’s 500)
250
200
50
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Source: Bloomberg.
186
ITALY
C ONCLUDING REMARKS
The foregoing account reveals the radical, albeit gradual, transformation of the
Italian financial system. Change has taken the same direction as international
finance, which in Europe has also been reflected in community directives. In
some sectors and in some respects, this has resulted in Italy’s having achieved
practically full convergence—in the predominance of securities, the financial
markets and intermediaries specializing in securities business and in the pri-
vate ownership of credit institutions.
In other fields convergence is clearly proceeding and will certainly be com-
pleted not only in derivatives and investment funds but also in the use of the
new payment system and international openness. In other areas Italy is mov-
ing slower than other countries. The main surviving anomaly of the Italian
financial system is the backwardness of private pension funds, tied to the coun-
try’s present retirement provisions based on the public sector pay-as-you go
system.
187
CASE STUDIES AND CROSS-COUNTRY REVIEWS
The intermediate objective pursued by the Bank of Italy for more than
25 years has been largely achieved: more competition in banking, together
with a sizable number of mergers and a start on reorganizations that have
increased efficiency and presage further advancements in the near future.
Competition has produced its effects on the prices of intermediation—it has
leveled them and kept them down. The competition within Italy’s financial
industry is now comparable to that of other advanced economies, but it can
be increased further. The Italian banking and financial system is still rela-
tively fragmented and marked by a low level of concentration. Technological
innovation and advances in telecommunications have only recently begun to
produce their effects. The privatization of banks and markets and the reduced
scope for obtaining public support are stimulating more efficient structures.
Banks and markets are two alternative channels of finance, giving economic
agents a larger set of economic opportunities and thereby fundamental
choice.
Greater competition has contributed to the strengthening of the capital
base of Italian banks and to the reduction of systemic risk. The capital ade-
quacy ratios of the largest Italian banks, low in comparison with those of the
other G10 countries for some time, have improved significantly since the end
of the 1990s. In 2003 the average solvency ratio for the Italian banking stood
at 11.4 percent. (10.8 percent for the largest banks). Italian banks are speed-
ing up their preparation for the introduction new Capital Accord (“Basel II”).
A number of banks accounting for 55 percent of total banks’ assets have
already brought their credit process into conformity with international best
practices and meet the conditions for immediately beginning the activities
necessary for the validation of internal rating systems.
N OTES
1. For a full description and discussion, see Ciocca (2000); for more details
on Italian credit structures in the 1970s and 1980s, see Banca d’Italia (1984).
2. The ratio of gross financial assets (liquid assets, loans and securities) to real
wealth (plant, machinery, stocks, buildings and land)—Raymond Goldsmith’s
financial interrelation ratio—is estimated to have been 0.9 in 1980. This value
can be considered high, albeit below the peaks recorded in the 1970s, which were
anomalous in several respects. It was not lower than those recorded in the more
advanced economies of West Germany, France and Japan.
3. A universal bank can operate without maturity constraints and can carry
out all the financial activities that are not restricted by law.
188
ITALY
4. In 1998, the Single Act on Financial Intermediation was enacted. With this
law, a new institution was created: the asset management company, which made
it possible to overcome the segmentation of activities and allowed banking and
financial groups to centralize management functions and separate them from dis-
tribution (see Banca d’Italia, Economic Bulletin, No. 26).
5. Although with some important qualifications, such as the importance of
multiple banking relationships, which reduced the strength of bank-customer
relationships (see Garella and others 2000).
6. Calculated for stocks, the financial intermediation ratio reached a peak of
0.5 in the mid-1970s. Subsequently, the excessive growth of double intermedia-
tion, with the banks financing the special credit institutions, was rapidly reab-
sorbed. In 1980–81 the ratio had already fallen back to levels comparable to those
of France and Germany (0.4), though well above those of the United Kingdom
(0.3) and the United States (0.2). Credit intermediaries’ share of financial assets
declined continuously, albeit less rapidly, in the two following decades, and by
1997 it had fallen below 0.3, lower than the ratio in Germany (which had remained
around 0.4), similar to those in France and the United Kingdom and higher than
that in the United States (which had decreased to 0.15).
7. In the 1980s the growth of the market was due both to the increase in the
number of listed companies, from 134 to 223, and to their issues of new shares. In
the 1990s it stemmed from the rise in share prices and the privatization and list-
ing of major public sector companies. The number of listed firms has changed lit-
tle, standing at 271 at the end of 2003. Their value added is equal to some 8 percent
of GDP. Privatized companies account for more than half the growth in the stock
exchange since the last quarter of 1993, when the privatization program began in
earnest. New share issues by listed companies declined from 8 percent of total
stock market capitalization in the 1980s to 5 percent in the 1990s. Nearly three-
quarters of all listed companies are controlled de jure or de facto by a single share-
holder. Nonresidents hold just over 13 percent of the total value of listed shares.
8. Money and the most liquid monetary instruments (currency, deposits and
Treasury bills) fell from 44 percent of total financial assets in 1980 to 33 percent
in 1990 and 18 percent in 2000. Loans, especially short-term lending by interme-
diaries issuing liquid liabilities, also declined, from 25 percent in 1980 to the pre-
sent level of 20 percent. Bonds (notably longer-term government securities),
equities, insurance technical reserves and investment funds recorded a corre-
sponding increase in their share, which rose to more than half: it was 31 percent
20 years ago and is nearly 60 percent today. Issues of corporate bonds and com-
mercial paper still remain fairly limited, albeit growing in the wake of the intro-
duction of the euro.
9. The assets of banks operating in Italy vis-à-vis nonresidents grew from
$25 billion at the beginning of the 1980s to $94 billion in 1990 and $210 billion
in 2003. Between 1990 and 1997, including Italian banks’ branches abroad, resi-
dents’ foreign currency deposits plus nonresidents’ lira and foreign currency
189
CASE STUDIES AND CROSS-COUNTRY REVIEWS
deposits rose from 8.2 percent to 10.9 percent of total deposits, while lira and for-
eign currency loans to nonresidents increased from 5.8 percent to 6.7 percent of
total lending. The number of Italian banks’ branches abroad rose from 43 in 1980
to around 100 in 1990, and then remained at about that level over the last 10
years. That of foreign banks’ branches in Italy has increased uninterruptedly, from
24 in 1980 to 37 in 1990 to 91 at the end of 2003. The foreign banking and finan-
cial subsidiaries of Italian banking groups numbered 140 in 1992 and 182 in 1998.
In 1990 there were 7 subsidiaries of foreign banks in Italy, today there are 11.
Italian subsidiaries of foreign groups numbered 13, of which 10 belonged to EU
groups. The presence of Italian banks abroad was extended, thanks notably to the
acquisition of foreign banks. At the end of 2003, 23 Italian banking groups were
operating abroad; there were 75 foreign subsidiaries and 80 foreign branches.
Branches and subsidiaries located in non-EU countries numbered 50 and 42
respectively.
10. See, for example, Claessens and others (2001).
11. See Gambacorta and others (2001) for more details.
12. The difference would be 20 percentage points if the ratio were worked out
relative to GDP, which reflects the more limited depth of the Italian financial sys-
tem. It is not attributable to different investment strategies by Italian banks since,
as illustrated above, the share of securities and shares in total assets is similar to
that recorded for the euro area.
13. According to the last survey by the Banca d’Italia on loan recovery pro-
cedures by banks (on a sample representing 90.5 percent of total lending to Italian
residents), the time for recovery ranged, for the reference month of December
1999, from a maximum of six or seven years for bankruptcy proceedings or com-
position agreements between creditors and debtors, to around two years for pri-
vate settlements, the most frequent recovery procedure. The average recovery rate
is estimated to be around 38 percent of the amounts owed, with a substantial dis-
persion depending on terms and conditions of loans, such as the presence of col-
lateral (see Banca d’Italia, Economic Bulletin, No. 34).
14. The relevance of TARGET is confirmed by the system’s operating volume:
in its first year of activity it handled an average of more than 163,000 payments
totaling €925 billion a day. Cross-border transactions increased by 58 percent in
number and 6 percent in value between January and December 1999. The share
of transactions originated by Italian intermediaries is high in terms of number (25
percent), lower in terms of value (10 percent).
15. See Banca d'Italia, Annual Report, 2003.
16. See Violi (2004) for details.
17. Turnover in Italy in forward foreign exchange contracts and derivatives
amounted to $207 billion a day in 2003, nearly 10 times the level in 1995. Forward
foreign exchange transactions rose from just under $16 billion in 1995 to just
over $155 billion in 2003, essentially owing to the steep increase in foreign
190
ITALY
exchange swaps, whose share of the total rose from 33 percent to 72 percent. The
share of total trading accounted for by nonresident counterparts remained basi-
cally unchanged at about 75 percent. Daily turnover in exchange rate derivatives
grew from $1 billion to $4 billion.
18. The Panzar and Rosse (1987) model used by these authors cannot prop-
erly rank the degree of competition, when monopoly or perfect competition does
not hold. Also Bikker and Groeneveld (2000) find monopolistic competition in
all of the 15 EU countries they study.
R EFERENCES
Angelini, P., and N. Cetorelli. 2003. “The Effects of Regulatory Reform on Com-
petition in the Banking Industry.” Journal of Money, Credit and Banking
35(5): 663–84. [Also published as “Bank Competition and Regulatory
Reform,” Banca d’Italia, Temi di discussione 380.]
Banca d’Italia. Various Issues. Annual Report. Rome.
———. Various Issues. Economic Bulletin. Rome.
———. 1984. “Italian Credit Structures.” London: Euromoney Publications.
Barth, James R., Gerard Caprio Jr., and Ross Levine. 2001. “The Regulation and
Supervision of Banks around the World: A New Database.” Policy Research
Working Paper 2588. World Bank, Washington, D.C.
———. 2002. Bank Regulation and Supervision: What Works Best? NBER
Working Paper w9323. Cambridge, Mass.: National Bureau of Economic
Research.
Bikker, J.A. and J.M. Groeneveld. 2000. “Competition and Concentration in the
EU Banking Industry.” Kredit und Kapital 33(1): 62–98.
Cetorelli N., and R. Violi. 2003. “Forme di mercato e grado di concorrenza nel-
l’industria bancaria dell’area dell’euro.” Ente Einaudi, Quaderni di Ricerca,
35, Rome.
Ciocca, P. 1998. “Competition and Mergers in the Italian Financial System.”
Speech for “La concentrazione nell’industria dei servizi finanziari:aspetti
teorici ed esperienze internazionali.” BIS Review 99 (November).
———. 2000. “La nuova finanza in Italia.” Bollati Boringhieri, Torino.
Claessens, Stijn, Asli Demirgüç-Kunt, and Harry Huizinga. 2001. “How Does
Foreign Entry Affect Domestic Banking Markets?” Journal of Banking and
Finance 25(5): 891–911.
De Bandt, O., and E.P. Davis. 2000. “Competition, Contestability and Market
Structure in European Banking Sectors on the Eve of EMU.” Journal of
Banking and Finance 24(6): 1045–66.
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
Gambacorta L., G. Gobbi, and F. Panetta. 2001. “Il sistema bancario italiano nel-
l’area dell’euro.” Bancaria 57(3): 21–32.
Garella, P., L. Guiso, and E. Detragiache. 2000. “Multiple versus Single Banking
Relationships: Theory and Evidence.” Journal of Finance 55 (3): 1133–61.
Neven D., and L. H. Roller. 1999. “An Aggregate Structural Model of Competition
in the European Banking Industry.” International Journal of Industrial Organ-
ization 17(7): 1059–74.
Pagano, M., F. Panetta, and L. Zingales. 1998. “Why Do Companies Go Public?
An Empirical Analysis.” Journal of Finance 53(1): 27–64.
Panzar J. C., and J. N. Rosse. 1987. “Testing for Monopoly Equilibrium.” Journal
of Industrial Economics 35(4): 443–56.
Passacantando, F. 1996. “Building an Institutional Framework for Monetary
Stability.” BNL Quarterly Review 49(196): 83–132.
Shaffer, S. 2001. “Banking Conduct before the European Single Banking License:
A Cross-Country Comparison.” North American Journal of Economics and
Finance 12(1): 79–104.
Violi, R. 2004. “Tax Systems, Financial Integration and Efficiency of European
Capital Markets.” Ente Einaudi, Quaderni di Ricerche, 58, Rome.
192
JAPAN
Designed to foster growth, Japan’s postwar financial system contributed to
rapid economic expansion, instrumental in bringing about the “Japanese
Miracle”.1 But the 1980s and 1990s witnessed the surge and collapse of a
Japanese economic bubble under this same system. With mounting burdens
of nonperforming loans, the financial system has since been an issue of con-
cern in the Japanese economy’s “lost decade”.
As recent research indicates, an economic system that is successful within
one set of environmental conditions could fail if those conditions change.2
Such environmental changes need not be purely external. The overall institu-
tional arrangements for the system may not fit with the changing environ-
ment, making it somewhat incompatible or obsolete. The financial system of
postwar Japan has been described as a classic example of this phenomenon.
193
CASE STUDIES AND CROSS-COUNTRY REVIEWS
The coordination of bond issues and the partitioning of the domestic and
foreign markets
In keeping with its policy of fiscal balance, Japan did not begin issuing gov-
ernment bonds on a serious scale until after the 1970s. Most companies
obtained their long-term funding from the long-term credit banks, and con-
trols were in place on coupon rates and bond volume. Under these condi-
tions, the bond market lagged in its development. Foreign capital transactions
were also subject to constraints, with tight curbs on inflows of foreign capital
to protect domestic regulatory frameworks from outside influence.9
Japan thus established a rather controlled, bank-centered financial system
and achieved high economic growth with intensive capital injections into
strategic industries driven by the allocation of bank deposits and lending.10 In
194
JAPAN
the process, the generation of bank rents through regulated low interest rates,
together with the stabilization of business operations with the aid of assorted
regulations, allowed Japanese banks to orient themselves more toward quan-
titative expansion. With their net yields protected by regulations, the banks
enjoyed a structure that ensured higher returns as they accumulated more
deposits and extended more loans.11 Such banking behavior promoted the
tendency for the public to save more. As the branch network of banks
expanded, financial services to the public contributed to the rise in deposits,
enabling businesses to raise funds in the high-growth period.
12
Period average
6
–3
1955 1960 1965 1970 1975 1980 1985 1990 1995 2003
195
CASE STUDIES AND CROSS-COUNTRY REVIEWS
with the end of this pattern, the Japanese economy entered a phase of sta-
ble growth.
Second, the Japanese public had begun to express a desire for a shift in the
government’s growth-oriented policy goals. For example, public opinion
favored revisions to growth policy because the era of rapid growth had been
accompanied by increases in environmental pollution and other problems.
Furthermore, the people had demonstrated interest in the creation of a wel-
fare state. On the financial side, households had amassed significant pools of
financial assets (figure 2). As a result, their appetite for risk rose, and they
began seeking financial assets that generated higher returns.
Third, Japan had come under growing foreign pressure to deregulate and
open its markets. A heightened presence in the trade arena demanded that
Japan open its markets wider to foreign trade. It also came under pressure to
liberalize its capital markets.
1,500
1,200
900
600
300
0
1955 1960 1965 1970 1975 1980 1985 1990 1995 2002
196
JAPAN
15 Surplus
10 Household
5
Government
0
Overseas
–5 Corporate
(nonfinancial)
–10
Shortage
–15
1955 1960 1965 1970 1975 1980 1985 1990 1995 2002
Source: Cabinet Office.
197
CASE STUDIES AND CROSS-COUNTRY REVIEWS
P ROVISIONAL APPRAISAL
The choice of a bank-centered financial system afforded several advantages to
the Japanese economy during its developing stages. First, from a financing
standpoint, banks were skilled in absorbing small-scale savings.13 And they
channeled funding to strategically important industrial sectors, in line with the
government’s policies on industrial development. Eventually, though, the
198
JAPAN
35
30
25
20 Lending
outstanding
15
10
5
Nominal GDP
0
–5
1955 1960 1965 1970 1975 1980 1985 1990 1995 2003
80
60
40
20
0
1950 1960 1970 1980 1990 2000
Manufacturing Nonmanufacturing Individual Others
Source: Bank of Japan.
199
CASE STUDIES AND CROSS-COUNTRY REVIEWS
100
80
60
40
20
0
1950 1960 1970 1980 1990 2000
Wholesale & retail trade, Construction Electricity, gas, heat Transport &
eating & drinking places supply & water communications
Services Finance & insurance Real estate
100
80
60
40
20
0
1950 1960 1970 1980 1990 2000
Iron & steel General machinery Transportation machinery Electrical machinery
Foodstuffs & beverages Chemical products Textile products
Source: Bank of Japan.
200
JAPAN
economic transition into a phase of stable growth, coupled with the accumu-
lation of financial assets and globalization, prompted sweeping changes in the
flow of funds. This in turn sparked growing pressure for steps in financial lib-
eralization, preventing the banks from maintaining their frameworks for a
financial system marked by limited competition.
The Japanese government, in response, implemented a progressive, staged
schedule of financial liberalization. Under the circumstances, many banks
proved too slow in improving their earnings structure under new principles
of self-accountability, or in establishing frameworks for risk management.
These conditions bred the seeds for the eventual creation and collapse of the
speculative bubble and the nonperforming loans that emerged thereafter.
Some features come into sharper focus if some conclusions are based on
a comparative institutional analysis of the changes that have reshaped Japan’s
financial system.14
First, state involvement in market mechanisms was one of the principal
features of Japan’s high-growth era. The Japanese financial system was not left
to market forces. It was actively cultivated with an array of financial regula-
tions that governed deposit interest rates and different financial market
segments—and erected partitions between the domestic and foreign mar-
kets. These forms of government involvement facilitated the intensive allo-
cation of funds to strategically crucial industries, which set the stage for the
era of high economic growth. This approach differs from the neoclassical
paradigm of minimizing state involvement and fully harnessing market
forces.
Second, financial liberalization from the 1970s forward progressed only
gradually because of forces (the holdings of vested interests) that sought to
maintain the system’s traditional structures and customs. Inertia prevailed
despite the trend toward globalization, the information technology revolu-
tion and other sweeping changes under way in the setting for Japan’s finan-
cial system. Some studies suggest that Japan should have moved earlier, more
boldly and more swiftly to remove its regulatory barriers and make the tran-
sition to policies that limited the government role to the extension of market
mechanisms. In hindsight, within the political and economic climate of the
time, it would have been extremely difficult to make the timely transition.15
N OTES
1. This paper was prepared by Wataru Takahashi and Shuji Kobayakawa of
the International Department of the Bank of Japan. The authors thank Hirotaka
201
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Inoue, Yohei Kawana, Masao Fujiwara and Yukiko Sakai for their help, comments
and suggestions. The views expressed in this paper are solely those of the authors.
2. See, for example, Aoki (2001).
3. Later, automobiles and electronics evolved as strategic sectors.
4. Government-led economic activities functioned effectively when the inter-
est of the public was focused on growth rather than the distribution of wealth.
Distributing wealth through market forces is important when national standards
of living improve and the needs of the public diversify. In addition, the hard bud-
get constraint successfully prevented many developing countries from getting into
financial trouble.
5. Allen and Gale (2000) focused on the role of financial intermediaries to
alleviate informational asymmetries and drew several conclusions. First, during
the era of rapid growth, the profitability of the investment opportunities is rela-
tively easy to assess. So, bank-centered financing saves the cost of monitoring
potential borrowers. Second, as an economy grows and profitability diversifies, the
merit of delegated monitoring diminishes. In that case, various investment
appetites are satisfied more easily under direct financing.
During its era of rapid growth, the Japanese economy was driven by the clear-
cut policy goal of catching up with the rest of the industrialized world. Under
such circumstances, cultivating a bank-oriented financial system was arguably
the wise choice.
6. The opposite of a bank-oriented financial system is a market-oriented
financial system.
7. It has been pointed out that lending rates were not held at low levels if
examined on an effective basis by taking deposit yields into account. In the past,
firms were required to hold compensating balance with main banks (demand
deposit accounts that had been required to hold under a low interest rate in com-
pensation for borrowing at higher rates). Nonetheless, lending rates were arguably
held down to some extent in practice through the stabilization of bank opera-
tions. A more important point is that bank rents contributed to an expansion in
bank lending.
8. Monitoring was effectively done by specialized financial institutions.
9. Among the more recent cases of economic development, some countries
have relied on foreign capital—that is, foreign direct investment—to offset
domestic shortfalls in investment funding. In this respect, they followed signifi-
cantly different paths than Japan did in its high-growth era.
10. Bank-centered financial systems are able to support strategic investments
with the preferential extension of certain forms of credit. The government was
capable of monitoring the supply of capital to strategically important industries
through the lending activities of banks. Additionally, the Bank of Japan used
window guidance to encourage private banks to keep aggregate increases in loan
202
JAPAN
volume within limits deemed appropriate. Note, however, that window guid-
ance sought to limit aggregate lending by individual banks, and not the amount
of lending to individual companies.
11. On the surface, this may appear to be a contradiction. However, while
competition was limited among Japanese banks in different fields of specializa-
tion, it was intense among those operating in the same field. On top of that, banks
were eager to absorb deposits and actively competed for good customers. These
factors in turn contributed to improved business efficiency.
12. Open market, as opposed to interbank market, first appeared in Gensaki
transactions. As a result, disintermediation in the banking sector became acute.
13. By contrast, direct financing was not suited to the absorption of small-scale
savings because the small denominations for many financial products are still rel-
atively large and investors are directly exposed to corporate credit risk.
14. Comparative institutional analysis is an approach advocated by Professor
Aoki of Stanford University. Its main feature, in brief, is the assumption that
resource distribution within a given economic system depends on a variety of
socially supportive structures and institutions, including resource holdings, pub-
lic expectations and preferences, corporate technologies, social customs and
norms and the way corporations are organized. Applying the same logic to finan-
cial systems leads to the conclusion that resources will be allocated differently
under different financial systems in countries with different institutions and struc-
tures. It thus follows that not all financial systems will conform to the Anglo-
Saxon model in a market economy.
15. In reality, the task of weaning itself from a bank-centered financial sys-
tem has proven painful for Japan. Nonetheless, attention has focused on the pro-
motion of market-based indirect financing through methods of securitization
while maintaining the traditional bank-centered system. A classic example would
be the sale of a mutual fund by a bank. Despite the current difficulty associated
with the transition from a bank-centered to market-centered system, effectively
using financial products such as mutual funds while harnessing the existing finan-
cial system should have value as a means of fostering the development of market-
driven forms of indirect financing. Encouraging the development of capital
markets through securitization will be an important step for Japanese banks that
plan to participate in the securities business.
R EFERENCES
Aoki, Masahiko. 2001. Toward a Comparative Institutional Analysis. Cambridge,
Mass.: MIT Press.
Allen, Franklin, and Douglas Gale. 2000. Comparing Financial Systems.
Cambridge, Mass.: MIT Press.
203
R EPUBLIC OF KOREA
Financial globalization can be expected to have positive effects on economic
growth in the long run, because it expands available capital resources, reduces
capital costs and transfers advanced financial techniques across countries. But
financial globalization may reduce macroeconomic stability, by increasing finan-
cial institutions’ risk exposures and creating large unanticipated outflows of for-
eign capital. The expansion of speculative attacks by foreign portfolio investors,
such as hedge funds, has increased the likelihood that a currency crisis will occur
in response to massive outflows of foreign capital caused by “herding behavior”.1
Speculative attacks may also lead to contagion, as a foreign currency crisis in one
country spreads to other countries, regardless of their economic fundamentals, as
international investors form self-fulfilling expectations of collapsing asset values.
These problems highlight the importance of building a sound financial
system, by increasing transparency and strengthening prudential supervision
(box 1). Doing so is critical to maximizing the potential benefits of financial
globalization while moderating its negative effects, including the increased
likelihood of financial instability and foreign exchange crises.2
Beginning in the 1970s the Korean government selectively provided and
distributed capital to the real economic sector, mostly through financial insti-
tutions, as part of its high-growth strategy. The practice was a leading cause
of increased corporate debt ratios and the reduced soundness of the corpo-
rate sector, which translated into a rising number of financial institution insol-
vencies. The Republic of Korea did not establish a well designed system for
maintaining and improving financial soundness, mainly because information
about financial institutions was not transparent, the implicit government pro-
tection of depositors caused moral hazard at financial institutions and finan-
cial supervision and regulation were not implemented efficiently.
In this situation, large abrupt outflows of foreign portfolio capital, which had
been rapidly built up following capital account and financial liberalization in the
1990s, caused a currency crisis at the end of 1997 (figure 1 and table 1). The cri-
sis revealed the inherent weaknesses of the Korean financial sector. The interna-
tional financial institutions to which the Republic of Korea turned for emergency
support in the crisis (the International Monetary Fund [IMF] and the World
Bank) demanded across-the-board financial reforms, including the market exit
of insolvent financial institutions and the strengthening of banking supervision.
Their demands were the immediate reason the Korean government embarked on
financial restructuring with the aim of building a sound financial system.
204
REPUBLIC OF KOREA
B OX 1
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
B OX 1 C ONTINUED
206
REPUBLIC OF KOREA
207
CASE STUDIES AND CROSS-COUNTRY REVIEWS
B OX 1 C ONTINUED
Conclusion
Globalization and liberalization have been the main factors affecting
institution building in the financial sector in the Republic of Korea.
Had this institution building progressed swiftly in the early 1990s,
the currency crisis of 1997 could have been avoided. The crisis finally
triggered significant reform of the financial sector, fully opening
financial markets to foreigners. Sweeping structural changes have sta-
bilized the financial system. With successful financial restructuring,
the Korean economy recovered quickly and is now tied more closely
to market forces. But many problems still need to be resolved, includ-
ing the low recovery rate of public funds, the underdeveloped capi-
tal market, widespread moral hazard among market participants and
delayed restructuring of the nonbanking sector. The Korean govern-
ment will continue to turn the regulatory and supervisory mecha-
nism into an incentive-oriented mechanism, so that financial
institutions can pursue profit-oriented management.
Source: Korean Ministry of Finance and Economy.
20 Portfolio investment
15
10
FDI
0
–5
1980 1985 1990 1995 2002
Source: Bank of Korea.
208
REPUBLIC OF KOREA
Table 1
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
foreign capital. This requires a sound financial system and a stable macro-
economic environment, including an independent central bank and the legal
means to promote fiscal soundness.
The Republic of Korea revised the Bank of Korea Act in December 1997
to stipulate that the Bank of Korea is an autonomous organization that imple-
ments monetary policy independently. The make-up of the monetary policy
committee was also changed, to ensure that its decisions would be neutral. The
governor of the Bank of Korea became chairman of the committee, and the
number of members was reduced from nine to seven. All members of the
committee were also made to serve on a full-time basis.
After the outbreak of the currency crisis, the Republic of Korea’s fiscal
deficit increased, as a result of interest payments on the public funds raised for
financial restructuring and increases in the social welfare budget. To achieve
the target of a balanced fiscal account before 2003, in January 2001 the gov-
ernment proposed the Special Act for Fiscal Soundness. The draft legislation
provided for the setting of a three-year mid-term fiscal plan and its report to
the National Assembly, as well as for strengthening the requirements for sup-
plementary budgets and restricting the use of extra revenues. This act, how-
ever, was not passed.3 In June 2001 the government decided to include not only
the central government budget but also the budgets of local governments in
its consolidated budget and to begin reflecting this change in 2003, in a move
to raise fiscal transparency to international standards.
After the currency crisis, the Republic of Korea changed its exchange rate
regime from a market-average system to a free-floating exchange rate system.
In doing so, the government sought to establish an environment in which the
exchange rate moves freely in accordance with supply and demand conditions
in the market.4 Before the crisis exchange rate movements failed to fully reflect
upward or downward pressures, because the foreign exchange transactions
were held within a rigid band on day-to-day exchange rate fluctuations.5 As a
result, there were frequent cases of currency misalignments. In December 1997,
as the Korean won repeatedly rose to the upper limit of its daily fluctuation
range, bringing transactions to a halt each time, the government abolished the
limit on daily fluctuations, adopting a de facto floating exchange rate system.
210
REPUBLIC OF KOREA
Table 2
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
prompt corrective action system was introduced to help monitor ailing finan-
cial institutions regularly.
With the establishment of the legal and institutional grounds for forc-
ing insolvent institutions to exit the market, the belief that ailing financial
institutions could be forced from the market at any time has become wide-
spread; this in turn has become an incentive encouraging these institutions
to manage their assets in a sound manner. Between 1998 and 2002, 655 insti-
tutions (15 banks and 640 nonbank institutions) exited the market by busi-
ness permit cancellation, merger or dissolution (table 2). This number
represented 31 percent of the total number of financial institutions in exis-
tence at the end of 1997.
212
REPUBLIC OF KOREA
213
CASE STUDIES AND CROSS-COUNTRY REVIEWS
214
REPUBLIC OF KOREA
soundness of the financial system by facilitating both the market exit of insol-
vent financial institutions and the restoration of normal management at finan-
cial institutions showing signs of unsoundness (table 3).
Table 3
215
CASE STUDIES AND CROSS-COUNTRY REVIEWS
216
REPUBLIC OF KOREA
instruments and deposit amounts protected under the blanket coverage system.
As a result of the revision, interest on deposits of more than 20 million won
made after August 1998 was excluded from protection, and investment products
such as repurchase agreements, certificates of deposit and bonds issued by banks,
as well as deposits made by government agencies, local authorities, the Bank of
Korea and the Financial Supervisory Service, were no longer protected.13
Meanwhile, the government revised the enforcement decree of the act in
June 2000 to return to a partial deposit guarantee system, as originally
intended in order to prevent moral hazard and enhance market discipline.
Concerned about possible instability in the market caused by huge abrupt
capital movements in returning to a partial guarantee system, the government
made it clear that a depositor’s funds were guaranteed up to the very sub-
stantial amount of 50 million won per financial institution.
Even with the partial deposit guarantee system now in place, however,
some tasks remain to be carried out to prevent moral hazard at financial insti-
tutions and make sure that market principles can work. These tasks include
limiting the deposit guarantee coverage to an appropriate level, introducing
premiums that are separately risk-adjusted for different financial institutions
and strengthening the principle of system beneficiaries contributing to the
insurance fund. Currently, the 50 million won guarantee for each depositor is
four times 2002 per capita gross domestic product (GDP)—higher than both
the IMF guideline of less than twice per capita GDP and the average level of
coverage in major countries (table 4). Moreover, premiums are not adjusted
to take account of different risk levels at different financial institutions,14 while
the Deposit Insurance Fund relies heavily on bond issuance rather than con-
tributions from the beneficiary institutions (table 5).15
Table 4
217
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Table 5
218
REPUBLIC OF KOREA
Table 6
laid down as part of the financial restructuring program that banks achieve
at least an 8 percent capital adequacy ratio.
Asset soundness indicators have also improved significantly. With the intro-
duction of forward-looking criteria in December 1999, Korean financial insti-
tutions began looking more closely at borrowers’ debt repayment capacity and
strictly controlling their credit risk. To improve cash flow and future profits,
they sold many of their nonperforming assets to the Korea Asset Management
Corporation and wrote off many bad debts. Despite an overall increase in total
loans in the Republic of Korea, the ratio to total loans of loans overdue for three
months or more and loans on which interest was not being paid dropped from
8.3 percent as of the end of 1999 to 1.9 percent at the end of 2002 (table 7). The
percent of total loans that were substandard or worse also declined substan-
tially, from 13.6 percent at the end of 1999 to 2.4 percent at the end of 2002.16
Korean banks’ return on assets and return on equity figures, which were
negative right after the currency crisis, moved into positive territory in 2001.
This is in part attributable to financial institutions’ efforts to reduce their non-
performing assets and increase profitability. Return on equity rose sharply,
from 3.8 percent in 1996 to 11.67 percent in 2002 (table 8).
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
Table 7
Table 8
220
REPUBLIC OF KOREA
distribution of funds and diversifies risk, all of which lead to savings growth
and higher efficiency in investment, ultimately boosting economic develop-
ment.17 Institution-building efforts in the financial sector are thus likely to
have a positive effect on economic growth. An opposing view holds that it is
economic growth that accelerates financial industry development, because an
expanding real economy demands more financial services.18
What is the relationship between financial industry development and eco-
nomic growth in the Republic of Korea before and after the currency crisis?
Did the institution-building efforts in the financial sector contribute to eco-
nomic growth after the crisis?
Empirical research was conducted, based on the methods used by
Demetriades and Hussein (1996) and Al-Yousif (2002),19 who analyze the rela-
tionship between financial development and economic growth using the
Granger causality test. The ratio of external finance (the sum of loans made
by financial institutions and market capitalization) to nominal GDP was used
as the proxy variable for measuring financial development.20 The proxy vari-
able for economic development was the natural logarithm of real GDP.21 Data
used cover 1990–2000 on a quarterly basis. To determine the impact of insti-
tution-building on economic growth, the analysis compares variables taken
from the period between first quarter 1990 and fourth quarter 2002 with those
from the period before institution building (first quarter 1990 and third quar-
ter 1997).22
Before the currency crisis, when institution building was not active,
there was no statistically significant causal relationship between financial
development and economic growth (table 9). For the entire period through
2002, however, the level of financial development is useful in explaining eco-
nomic growth, with time lags of one to four quarters. That is, there is evi-
dence of causality running from financial development to economic growth.
(When the time lag reaches five and six quarters out, the variable for eco-
nomic growth explains financial industry development, suggesting reverse
causality.23)
These results are not sufficient for concluding that institution-building
efforts in the financial sector after the currency crisis enhanced financial
soundness, which in turn accelerated economic growth. But given the signif-
icance of financial development in explaining economic growth, it is very
likely that the series of institution-building measures contributed to financial
deepening and increased efficiency in the financial industry, thereby inducing
economic growth.
221
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Table 9
222
REPUBLIC OF KOREA
223
CASE STUDIES AND CROSS-COUNTRY REVIEWS
N OTES
1. “Herding behavior” refers to the pattern of behavior in which investors fol-
low leaders in order to save on the expenses of gathering and processing country-
specific information. If the leading investor makes a wrong decision, a currency
crisis or other panic may occur, because other investors also decide wrongly
(Calvo and Mendoza 1998). “Momentum trading” may be thought of as a type
of herding behavior. In momentum trading, investors who lack information
regard an upward price trend as a signal that leading investors recognize an asset
as a good buy and follow their lead in buying it. When the price is declining,
investors follow the falling trend and sell.
2. IMF (2002) recommends a phased institution-building of the financial
system in advance of complete capital liberalization as follows: revising the finan-
cial legal framework, improving accounting and statistics, strengthening systemic
liquidity arrangements and related monetary and exchange operations, strength-
ening prudential regulation, restructuring the financial and corporate sectors and
developing capital markets.
3. The Framework Act on Public Funds Management, which seeks to heighten
fiscal discipline in the management of public funds, was passed in March 2002.
4. In the market-average exchange rate system, the target exchange rate for the
day was set by computing the previous day’s transaction volume–weighted average
of the Korean won’s rate against the dollar in the interbank market. Transactions
were made within a limited range of fluctuation around the target rate.
5. The daily range of fluctuation was widened seven times between 3 March
1990 and 20 November 1997.
224
REPUBLIC OF KOREA
225
CASE STUDIES AND CROSS-COUNTRY REVIEWS
migrated on a very large scale into fixed deposit accounts at banks or beneficiary
certificates at investment trust management companies.
226
REPUBLIC OF KOREA
economic growth, the entire 1990–2002 period was used for estimation, as the
period following the crisis was too short for analysis.
23. The empirical study by Demetriades and Hussein (1996) also found bi-
directional causality between the Republic of Korea’s financial industry develop-
ment and its economic growth.
24. Such extraordinary occasions will include massive natural disasters, seri-
ous changes in economic conditions at home and abroad and cases in which a
need for government budgetary spending arises after the budget has been set.
R EFERENCES
Al-Yousif, Y.K. 2002. “Financial Development and Economic Growth: Another
Look at the Evidence from Developing Countries.” Review of Financial
Economics 11 (2): 131–150.
Bank of Korea. 2002. “Financial System in the Republic of Korea.” Seoul.
Bencivenga, V. R., and B. D. Smith. 1991. “Financial Intermediation and Endog-
enous Growth.” Review of Economic Studies 58 (2): 195–209.
Brennan, M.J., and H.H. Cao. 1997. “International Portfolio Investment Flows.”
Journal of Finance 52 (5): 1851–80.
Calvo, Guillermo A., and Enrique Mendoza. 1998. “Rational Herd Behavior and
the Globalization of Securities Markets.” Working Paper 97-26. Duke
University, Department of Economics, Durham, N.C.
Cheong, I.J., and J. S. Cha. 2001. “Study on Financial Stability.” Bank of Korea,
Seoul.
Demetriades, P.O., and K.A. Hussein. 1996. “Does Financial Development Cause
Economic Growth? Time-Series Evidence from 16 Countries.” Journal of
Development Economics 51 (2): 387–411.
Garcia, Gillian G.H. 1999. “Deposit Insurance: A Survey of Actual and Best Practices.”
IMF Working Paper 99/54. International Monetary Fund, Washington, D.C.
Goldsmith, R. 1969. Financial Structure and Development. New Haven, Conn.:
Yale University Press.
Greenwood, J., and B. Jovanovic. 1990. “Financial Development, Growth, and
the Distribution of Income.” Journal of Political Economy 98 (5): 1076–1107.
Hwang, S.I., Y.J. Wang, and S.B. Lee. 1999. “Adjustment Reforms in the Republic
of Korea Following the Financial Crises: A Comprehensive Report.” Korea
Institute for International Economic Policy, Seoul.
IMF (International Monetary Fund). 2002. “Capital Account Liberalization and
Financial Sector Stability.” Occasional Paper 211. Washington, D.C.
———. 2003. “Republic of Korea: Financial System Stability Assessment, includ-
ing Reports on Observance of Standards and Codes on the Following Topics.”
Country Report 03/81. Washington, D.C.
227
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Khan, A. 2000. “The Finance and Growth Nexus.” Business Review (January/
February): 3–14. Federal Reserve Bank of Philadelphia, Pa.
Kim, B.D., W.J. Kim, and S.J. Lee. 2002. “An Appraisal of the Past Four Years of
Financial Restructuring of Korea.” Korea Institute of Finance, Seoul.
Korea Deposit Insurance Corporation. 2002. Annual Report. Seoul.
Korea Financial Supervisory Service. 2002. Banking Statistics. Seoul.
Lindegren, C. J., G. Garcia, and M.I. Saal. 1996. Bank Soundness and Macroecono-
mic Policy. Washington, D.C.: International Monetary Fund.
Masson, Paul R. 1998. “Contagion: Monsoonal Effects, Spillovers, and Jumps
between Multiple Equilibria.” Working Paper 98/142. International Mone-
tary Fund, Washington, D.C.
McKinnon, R.I. 1973. Money and Capital in Economic Development. Washington,
D.C.: Brookings Institution.
Robinson, J. 1952. The Rate of Interest and Other Essays. London: Macmillan.
Shaw, E. 1973. Financial Deepening in Economic Development. New York: Oxford
University Press.
Zang, H.S., and Y.J. Wang. 1998. “Adjustment Reforms in Korea Following the
Financial Crises: A Comprehensive Report.” Korea Institute for International
Economic Policy, Seoul.
228
M EXICO
Institutions—the rules, enforcement mechanisms and organizations that
shape the functioning of markets (North 1990, 1991)—have long been rec-
ognized as fundamental for economies to function properly. Institutional
development in the financial sector is particularly important because of the
role of efficient and sound financial systems in promoting economic
development—but also because the quality of the institutional financial
framework is crucial for countries to reap the benefits of international capi-
tal flows and to minimize the costs of volatility and contagion.
The Mexican experience illustrates the positive influence of liberalization
and globalization on institution building, the dangers of financial liberaliza-
tion not accompanied by strong institutions and the merits of basing reform
efforts on institutional elements to avoid backward movements during peri-
ods of temporary difficulty.
229
CASE STUDIES AND CROSS-COUNTRY REVIEWS
230
MEXICO
into a modern, highly competitive and efficient system. The central bank’s
autonomy was an important achievement in the institution-building process
in Mexico during this period.
231
CASE STUDIES AND CROSS-COUNTRY REVIEWS
common stock was permitted in Mexican commercial banks and financial hold-
ing companies. The same limit was established for foreign investment in securi-
ties intermediaries.
232
MEXICO
233
CASE STUDIES AND CROSS-COUNTRY REVIEWS
234
MEXICO
public indebtedness, as well as a primary surplus target for PEMEX (the state
oil company), the budget over the last few years has included automatic adjus-
tors, which provide for saving the bulk of excess revenue and require offsetting
expenditure cuts in the case of revenue shortfalls.4 Although the government
retains discretion in applying these adjustors, the authorities have a track record
of abiding by the adjustors to ensure compliance with the fiscal targets. Even
if the government opted to ignore the adjustors, the debt ceiling included in the
annual revenue law would provide a legal limit to the overall nominal deficit—
and thus an indirect obligation to adjust expenditure.
235
CASE STUDIES AND CROSS-COUNTRY REVIEWS
private sector. With the new laws, both creditor rights and the efficiency of loan
collection were significantly enhanced.
Second, in July 1997 a pension system began operating based on an indi-
vidual capitalization scheme. Contributions by employees, employers and
the government are deposited and registered in a personal account owned by
the employee. These accounts are administrated by financial entities called
Administration for Retirement Funds.5 By shifting from a pay-as-you-go
system to a fully funded individual capitalization scheme, the reform
strengthened the link between contributions and benefits, enhancing overall
financial soundness. Although the impact of the scheme on domestic saving
is difficult to quantify, it is useful to note that in June 2004 resources out-
standing under the system amounted to 10.9 percent of GDP and 21.8 per-
cent of financial savings (monetary aggregate M2).
236
MEXICO
Commercial banking
Although progress in enhancing the strength and efficiency of commercial
banks in 1995–2000 was substantial, important problems remain. Due to the
decline in bank credit to the private sector, commercial banks have not sup-
ported economic activity adequately. This is explained to an important extent
by the fact that further efforts were needed to provide legal certainty to cred-
itors through appropriate guarantees and loan recovery mechanisms. More-
over, the reforms to the regulatory and supervisory framework for the banking
system carried out during the period 1996–2000, though important, were
insufficient to substantially reduce the possibility of a new banking crisis. In
addition, the Mexican financial system lacked a basic institutional component
to allow banks to provide financing on a healthy basis: credit information
societies. Against this background, the following laws and amendments were
approved by Congress:
237
CASE STUDIES AND CROSS-COUNTRY REVIEWS
• The Credit Institutions Law and the Financial Groups Law, aim to
channel a greater portion of national savings through the financial
system, fostering long-term savings, strengthening banking regulation
and supervision and promoting transparency, competitiveness and
the development of new financial products and services. These laws
also strengthen the credit institutions’ corporate governance and
broaden the range of services offered.
• Amendments to the Rules of Capitalization Requirements for Multiple
Banking Institutions aim to advance the convergence between bank-
ing regulation and international standards, particularly banking
capitalization recommendations proposed by the Bank for Inter-
national Settlements.
• Amendments to the Miscellany on Credit Collateral promote bank
lending by reducing transaction costs and interest rates and by widen-
ing the options to secure credit transactions and promote competi-
tion among trustees. The amendments will grant greater judicial
certainty to creditors and borrowers, thus promoting an orderly and
sustainable recovery of bank lending.
• The Credit Information Institutions Law regulates the establishment
and operation of credit information societies and sets transparent
rules for creating and repealing this kind of societies, by establishing
a legal framework for them to function adequately in the provision
of credit information, while ensuring that financial secrets are
respected.
• The Banking Law establishes parameters and objectives in order to
regulate the preventive actions of the National Banking and Securities
Commission, when an institution is above or beneath the capital stan-
dards and requirements.
• The Law for the Transparency and Ordering of Financial Services reg-
ulates commission fees, interbanking fees and other aspects related
with the provision of financial services. It also prohibits discrimina-
tory practices between credit institutions and also between its users;
establishes transparency requirements in contracts and check
accounts balances, credit and debit cards; foresees transparency
mechanisms to allow clients of credit institutions to know the carried
out transactions and their fees; and establishes sanctions for breaches
of the law.
238
MEXICO
Development banks
The sharp increase in development bank lending during 1990–94 was not
accompanied by appropriate evaluation processes or credit infrastructures, lead-
ing to important losses. As a result, net financing from development banks dur-
ing 1995–2000 was basically nil. With the objective of widening access of the
population to financial services and to promote the creation of small and
medium-size firms, PRONAFIDE proposed a deep transformation of develop-
ment banks. This has included better corporate governance, greater autonomy
and more accountability. In addition, Congress approved the following laws:
• The Organic Law of the Federal Mortgage Association increases the hous-
ing supply for wage earners and other workers, promotes the con-
struction and acquisition of housing, preferably low-income, fosters
assets securitization and increases credit supply for housing construc-
tion and acquisition.
• The Popular Savings and Credit Law and The Organic Law of the Bank
of National Savings and Financial Services strengthen the institutional
and regulatory framework of popular savings and credit activities,
increasing access of low-income sectors and small enterprises to the
formal financial sector. They also establish the conditions to foster the
development of a popular savings and credit system. Through these
laws the Bank of National Savings and Financial Services was cre-
ated, offering training and consulting services to popular savings and
credit entities, and regulating their activities and operations.
• The Organic Law of the Financiera Rural aims at supporting the
development of agriculture, forestry, fishing and other rural activities.
A new Financiera Rural has replaced the former Rural Credit Bank
(BANRURAL). The Financiera does not take deposits from or issue
debt to the public. The funding comes directly from the government
through the budget. All appropriations, allocations, financing and
guarantees will be properly and explicitly accounted for in the bud-
get and approved by Congress.
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
accounting for only a small share of the total (1.3 percent in June 2004). To
overcome these difficulties, in 2001, Congress approved reforms to the
Securities Market Law and to the Mutual Funds Law. These changes aim at
promoting the development of the securities market by making it more trans-
parent, efficient and liquid. They provide more protection to investors and
create a transparent corporate mechanism through several channels, such as
an enhanced provision of information, better corporate governance prac-
tices and explicit rights for minority stockholders. Further developments on
those objectives—such as a consolidated regime applicable to public com-
panies and the promotion of access to a broad securities market to small and
medium-size firms, are considered in the project of a new Securities Market
Law. An important additional action in the Mexican debt market was the
introduction of a new versatile instrument, “Certificado Bursátil” (a securi-
tized note), that can be issued by private and public debtors. Another result
of the legal reforms was the incorporation to the market structure of clear-
ing houses. These institutions, responsible for the liquidation and compen-
sation of operations, reduce systemic risk in the securities market.
Insurance
The structure of the insurance sector has been strengthened through the cre-
ation, merger, acquisition and alliance of firms, but its size remains very small
for international standards. For this reason, the General Law of Mutual Insur-
ance Institutions and Associations seeks to strengthen the institutional and
regulatory framework for the activities of insurance institutions. It seeks to
increase the efficiency of insurance institutions’ operations, to consolidate the
insurance sector’s legal framework with that in place for the financial sector
and to develop best corporate governance practices among intermediaries.
Pension system
The reform of the pension system in 1997 is one of the most important structural
measures of the last years. In addition to ensuring the financial viability of pen-
sions, it has stimulated the expansion of long-term financial savings as well as a
higher participation of workers in the formal labor market. To reinforce the sys-
tem in its strategic areas, Amendments and Additions to the Retirement Savings
System Law open the possibility for more workers to access the benefits of the New
Pension System, including workers not registered in a social security regime,
workers affiliated with the social security system for public sector employees, state
and municipal governments, public universities and private pension funds.
240
MEXICO
Payment system
Banco de México began a gradual reform in 1994 to achieve a balance between
the objectives of reducing risks in the system and maintaining an adequate
operational efficiency in financial markets. Since 2001 reform efforts have
focused on revamping the legal framework in order to ensure payment final-
ity and improve the execution of collateral and the oversight powers of the cen-
tral bank. Banco de México also implemented a plan to eliminate remaining
credit risks in the payment systems, in line with its objective of complying
with the Bank for International Settlements Core Principles for Systemically
Important Payment Systems.
In 2001 Banco de México announced to financial institutions a sequence
of measures that would be implemented within the following three years. The
first, introduced in February 2002, requires that any overdraft in the large-
value electronic payment system be settled in the same day by using bilateral
credit lines provided by other banks. In the last quarter of 2002, additional
measures were adopted to improve the quality of collateral associated with
Banco de México’s credit and to consolidate the intraday credit into one pay-
ments system from the prevailing three.
241
CASE STUDIES AND CROSS-COUNTRY REVIEWS
In 2001 a joint IMF–World Bank mission carried out a Financial Sector Assess-
ment Program (FSAP), which had as important inputs reports on the obser-
vance of standards and codes and good practices of transparency in monetary
and financial policies, payment systems, banking supervision, objectives and
principles of securities regulation from the International Organization of
Securities Commissions and supervisory principles from the International
Association of Insurance Supervisors.
The FSAP proved useful for Mexico for several reasons. It represented an
input for the financial reform measures that were introduced in 2001. Discus-
sion with the FSAP team allowed the authorities to exchange views and to
confirm that the chosen path was the correct one. Self-assessments by each
institution as background for the FSAP compelled them to review the
strengths and weaknesses of the financial system and its institutions against
an international point of reference.
Although international financial institutions can be an important force
behind countries’ efforts to reinforce institution building in their financial sec-
tors through such initiatives as FSAPs and standards and codes assessments, the
process is not free of problems. First, many countries have expressed concerns
about the appropriateness of the existing standards and codes for their stage
of development, showing the importance of country involvement in the design
of standards and codes. Second, to be useful in the medium and long terms,
such exercises need to be updated frequently. But, capacity constraints make this
unlikely. Third, it is not clear whether markets are taking sufficiently into
account the evaluations made by the IMF and the World Bank under FSAPs.
242
MEXICO
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
review the banking system’s normative scheme and to implement the measures
needed, if any, to ensure a healthy growth of bank credit.
N OTES
1. In the last two and a half decades, the Mexican authorities have striven to
develop domestic debt markets. The initial steps date back to this first issue of gov-
ernment peso-denominated fixed-rate securities. Initially, both the number of
market transactions and the amounts involved were small; securities had short-
term maturities, no secondary market existed, and the government determined
interest rates. But, over the years both the government and the central bank
increasingly relied on the debt market, the former to cover its financial needs and
the latter as an instrument of monetary policy.
2. In August 1993, Congress approved an amendment to Article 28 of the
Mexican Political Constitution granting autonomy to the central bank. The pri-
mary objective of the autonomous central bank under the new Article 28 is to seek
the stability of the purchasing power of the national currency. In addition, Congress
passed a new law for Banco de México that went into effect on 1 April 1994.
3. Under this framework, Banco de México established a medium-term inflation
objective with well defined annual targets consistent with this objective. The medium-
term objective was set at around 3 percent by end-2003 (end-year headline consumer
price inflation), with intermediate targets of under 6.5 percent in 2001 (the observed
inflation rate was 4.4 percent) and under 4.5 percent for 2002 (the observed inflation
rate was 5.7 percent). In July 2002, Banco de México formally established the 2003
inflation target at 3 percent and announced that from 2004 onward it would be main-
tained at 3 percent with a variability interval of ±1 percent around the midpoint.
4. Automatic stabilizers currently operate under the following guidelines:
• In particular, automatic stabilizers are triggered if government revenues
are lower than anticipated:
• If oil related revenues are lower than anticipated, the shortfall can be off-
set with up to 50 percent of the resources accumulated in the Oil
Stabilization Fund, plus interest earnings and other less important
sources.
• If other revenues are lower than anticipated then:
– If revenues decrease by 5 percent of tax revenues or less, the govern-
ment will cut programmable expenditures and inform Congress of
the items where these expenditure reductions will be carried out. In
case the previous adjustments are not enough to compensate for the
revenue shortfall, the government will be entitled to adjust other
expenditure items.
– If the reduction in revenues is larger than 5 percent of tax revenues,
programmable expenditures will be reduced. In this case, Congress
will have to approve the specific items where the expenditure adjust-
ments will take place.
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MEXICO
R EFERENCES
Aspe P. 1993. Economic Transformation: The Mexican Way. Cambridge, Mass.,
and London: MIT Press.
Aziz, J., and C. Duenwald. 2002. “Growth-Financial Intermediation Nexus in
China.” Working Paper WP/02/194. International Monetary Fund,
Washington, D.C.
Banco de México. Various issues. The Mexican Economy. Mexico City.
———. Various issues. Annual Report. Mexico City.
Beck, T., R. Levine, and N. Loayza. 1999. “Finance and the Sources of Growth.”
Journal Financial Economics 58(1–2): 261–300.
Bekaer, G., C. Harvey, and C. Lundblad. 2001. Does Financial Liberalization Spur
Growth? NBER Working Paper 8245. Cambridge, Mass.: National Bureau of
Economic Research.
Carstens, A., and F. Gil Díaz. 1996. “Some Hypotheses Related to the Mexican
1994–95 Crisis.” Documento de Investigación 9601. Banco de México, Mexico
City.
Conesa, A., M. Schwartz, A. Somuano, and A. Tijerina. 2003. “Fiscal Rules in
Mexico.” In George Kopits, ed., Rules-based Fiscal Policy in Emerging Markets:
Background, Analysis and Prospects. New York: Palgrave Macmillan.
Coorey, Sharmini. 1992. “Financial Liberalization and Reform in Mexico.” In
“Mexico: The Strategy to Achieve Sustained Economic Growth.” Occasional
Paper 99. International Monetary Fund, Washington, D.C.
Cukierman, Alex. 1992. Central Bank Strategy, Credibility and Independence:
Theory and Evidence. Cambridge, Mass.: MIT Press.
De Gregorio, J. 1998. Financial Integration, Financial Development and Economic
Growth. Center for Applied Economics, Department of Industrial Engin-
eering, Universidad de Chile, Santiago.
Dooley, M. 1997. “Financial Liberalization and Policy Challenges.” Working
245
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246
MEXICO
247
S AUDI A RABIA
Since the dawn of its modern history, Saudi Arabia has been an open and lib-
eral economy benefiting from free movement of goods, services, capital and
human resources. It has thus supported international efforts towards a more
globalized and interlinked world economy. It has also recognized the impor-
tance of institution building to ensure that the country can develop an econ-
omy with strong and stable fundamentals, which can allow an optimal
participation in the global market as well as absorb external shocks that may
arise in the global economy.
This experience is best presented in the context of the evolution of the
Saudi Arabian banking system and the role of the central bank, the Saudi
Arabian Monetary Agency (SAMA), in the institutionalization of the finan-
cial market. For over half a century Saudi banks and SAMA have been the key
players in the Saudi financial system in four distinct phases—the genesis, the
adolescence of the 1970s, the trials and tribulations of the 1980s and the
restructuring for growth of the 1990s leading into the prospects for the new
millennium.
248
SAUDI ARABIA
to the dollar. Foreign currency reserves rose, inflation was held down, and the
government issued paper currency to replace all Pilgrim Receipts.
Growing pains. In 1960 Riyad Bank and Al Watany Bank faced serious liq-
uidity problems arising from mismanagement and improper loans by board
members in both banks. By 1960 Al Watany Bank was technically insolvent
and was unable to settle the claims of local depositors. SAMA liquidated the
bank and merged its operations with Riyad Bank. In 1961 SAMA required
Riyad Bank to reorganize, and with the government’s approval, SAMA acquired
38 percent of the shares of the bank. These events tested the government’s
resolve to defend the stability of the nascent banking system. The government
not only took action by requiring a merger—it also came in strongly as a share-
holder to prevent the bank failure. This sent a clear signal that Saudi authori-
ties wanted to fully support a strong, stable and credible banking system. Even
with the government’s ownership stake, Riyad Bank continued to operate as a
private sector institution with no major interference from the authorities.
Strengthening the regulatory framework. A new Banking Control Law in
1966 gave SAMA broad supervisory powers to license and regulate all banks,
which had to meet stringent capital adequacy, liquidity, lending ratios and
reserve requirements. A system of on-site and off-site prudential supervision
was introduced, and SAMA strengthened its supervisory capabilities. The law
also supported the concept of a Universal Banking Model, which permitted
banks to provide a broad range of financial services through their branches,
including banking, investments and securities. Banks thus became the pri-
mary licensed financial institutions, expanding rapidly.
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
small remote communities were also served by more than 250 branches of money
changers providing currency exchange and other minor financial services.
Special purpose government funds. In addition to the banks and money
changers, the government created five major lending institutions in the 1970s:
the Saudi Credit Bank, the Saudi Agricultural Bank, the Public Investment
Fund, the Saudi Industrial Development Fund and the Real Estate Fund. These
institutions provided medium- and long-term development finance to sup-
plement the short-term funds provided by commercial banks. They played a
key role in financing the medium- and long-term capital needs of the nascent
industrial sector. They also freed up the banks to pursue less risky short- and
medium-term financing, essential at the early stage of development when the
economy lacked a modern infrastructure and a trained human resource base.
Restructuring foreign banks. The government had always encouraged for-
eign banks to open branches within the country and by 1975 there were 10
international banks with 29 branches. With the Second Five-Year Plan, com-
mencing in 1976, the government promoted a policy of converting foreign
banks’ branches into publicly traded companies with the participation of
Saudi nationals. The incorporation and share floatations of these banks
encouraged broad public participation and contributed to the development
of a stock market. This also promoted the formation of banking habit among
the Saudi people. And by encouraging foreign banks to take large sharehold-
ings in the newly incorporated banks and by offering them management con-
tracts, the foreign partners could exercise significant management control and
benefit from national treatment accorded to banks fully owned by Saudis. By
1980 banks in operation had substantial foreign ownership, and the number
of bank branches had risen to 247. Moreover, these institutions still play a
great role in providing credit to the various economic sectors.
250
SAUDI ARABIA
251
CASE STUDIES AND CROSS-COUNTRY REVIEWS
252
SAUDI ARABIA
253
CASE STUDIES AND CROSS-COUNTRY REVIEWS
Economic boom and bank recapitalization. After the Gulf crisis there was a
mini boom. In 1991 there was a surge of about 20 percent in the deposits of the
banking system. Banks’ domestic loans and advances grew 90 percent during
1990–95. And all other banking indicators—including rate of return on equity
and average assets—continued to be highly positive, with many banks making
record profits. Despite difficult international conditions, the banks continued
to show stable growth and strong profitability in the second half of 1990s.
Strengthening the capital base of the banks. The Saudi banks used the bull-
ish sentiments in the stock market to raise substantial amounts of capital. Six
of the 12 banks increased their capital during 1991–92, and three Saudi banks
went to the market during 1993–97.
Mergers and acquisitions for further consolidation. The restructuring of the
banking system continued with the 1997 merger of United Saudi Commercial
Bank and Saudi Cairo Bank into United Saudi Bank. In 1999 United Saudi
Bank merged with Saudi American Bank to form the third largest bank in the
country. This consolidation of Saudi banks was driven primarily by share-
holders wishing to maximize share values and believing that size matters.
Technological investment in the shares market. In August 1990 SAMA intro-
duced a major enhancement of shares market by unveiling an electronic share
trading and settlement system. This system encouraged banks to open their
vast branch network to investors who wished to trade in shares. The paper-
less system made share certificates obsolete and permitted same day trading
and settlement. The shares and values traded grew dramatically over the
decade. In 2001 the system was enhanced to handle government and corpo-
rate bonds, mutual funds and new investment products.
254
SAUDI ARABIA
255
CASE STUDIES AND CROSS-COUNTRY REVIEWS
256
SAUDI ARABIA
permit trading of government bonds, Treasury bills and mutual funds in addi-
tion to corporate shares. This system, functioning as an electronic stock
exchange, is important to the implementation of the new Capital Market Law.
Saudi banks are now offering telephone and Internet banking services and
working to further promote electronic commerce.
New products and services. By the end of 2003 Saudi banks managed 170
investment funds with investments of SR53.9 billion and offered interna-
tional stock brokerage and fiduciary banking services. With Saudi Arabia as
one of the largest private banking markets in the world, the potential for
growth in this area is immense. Saudi Banks have recently entered bank assur-
ance, through joint-venture agreements with some of the leading insurance
companies to provide distribution of jointly labeled insurance products
through their branch networks. Also, the Saudi authorities have recently
licensed two leasing companies, joint ventures including major specialized
leasing companies and Saudi Banks. With the new Capital Market and
Insurance Laws, Saudi banks will compete with nonbank financial institu-
tions in the provision of these services. This will lead to rapid growth and
expansion of these sectors.
Another important area of growth for Saudi banks is noninterest (Islamic)
banking services, which now account for over 17 percent of the assets of the
Saudi banking system.
Credit ratings. In July 2003 a solicited sovereign rating for Saudi Arabia
was announced by Standard and Poor’s rating agency: A+ for local currency
and A for foreign currency borrowings. This first step will go a long way in
helping Saudi companies and financial institutions tap financial markets for
long-term funds. It will also encourage the development of an indigenous
rating agency and perhaps a Saudi corporate bond and commercial paper
market.
Nonbank financial institutions. The new Capital Market Law will give a
boost to the nonbank financial sector. Stock brokers, investment fund man-
agers, mutual funds, custodians, trustees and investment advisers are likely to
open businesses. Their proliferation will permit greater competition and diver-
sity and lead to lower costs and greater efficiency.
T HE WAY FORWARD
In this first decade of the new millennium the Saudi financial system is well
poised to leap ahead and take advantage of the strong base developed over the
past half century. It should be able to leverage its traditions of openness and
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
258
U NITED K INGDOM
The liberalization of the world’s financial markets and the rise in global finan-
cial services bring considerable benefits. But greater openness can raise expo-
sure to threats of financial instability. This reinforces the importance of strong
and effective financial frameworks and structures, particularly credible mon-
etary and fiscal policy frameworks supported by effective financial regulation.
This paper focuses on the United Kingdom’s experience since 1997 of
building institutions to deliver effective financial regulation and stability, the
drivers behind reform and the lessons learned.
The key elements of the United Kingdom’s reform process were the sep-
aration of banking supervision from the operation of monetary policy; the
creation of a single regulator covering banking, securities and insurance; the
establishment of a statutory framework within which the regulator is inde-
pendent of, but accountable to, the government in pursuit of statutory objec-
tives; and a tripartite arrangement whereby the finance ministry, monetary
authority and financial regulator regularly meet to address issues of financial
stability.1
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
other banks. The Banking Act 1987 and its related reforms abolished this sys-
tem in favor of a more consistent approach.
For a long time monetary and fiscal policy failed to make an adequate
contribution to high and stable levels of growth and employment. Inflation
was higher and more volatile than it would otherwise have been, in part
because the aims and procedures of monetary policy were not properly
defined. The post-1992 monetary framework addressed some but not all of the
past problems by introducing inflation targeting and greater transparency. As
a result, it was only partially successful and did not provide a durable solution.
The numerous changes in monetary arrangements were paralleled by
changing fiscal arrangements. There are a number of lessons to be learned
from the experience of previous cycles: primarily, that adjustment must be
made for the cycle, while maintaining a margin for uncertainty and to set sta-
ble fiscal rules and explain clearly fiscal policy.
260
UNITED KINGDOM
that seeks to ensure low and stable inflation and fiscal policy that is under-
pinned by clear objectives and two strict rules to ensure sound public
finances over the medium term and supports monetary policy over the eco-
nomic cycle.
Key elements of this framework were the transfer of operational respon-
sibility for monetary policy to the Bank of England and the creation of the
two new fiscal policy rules. The “golden rule” states that over the economic
cycle the government will borrow only to invest and not to fund current
spending. The sustainable investment rule states that public sector net debt
as a share of gross domestic product (GDP) will be held at a stable and pru-
dent level over the economic cycle.
These reforms created clear long-term policy objectives and increased
openness and transparency. They generated the credible pre-commitment to
an inflation target which had been lacking before.
Without a strong, flexible and accountable supervisory structure how-
ever, the threat of systemic crises in the financial sector might undermine the
positive effects on price stability and long-term policy predictability.
R EGULATORY REFORM
Financial markets have become increasingly globalized. In response, there has
been a movement toward unified financial regulators in a number of countries.
There are differing views about which institutional model is best at addressing
the changes brought about by globalization. A unified institutional structure
would:
• Exploit synergies between different areas of regulation and enable
economies of scale to be reaped.
• Be simpler to understand and recognize.
• Mirror market reality.
• Avoid regulatory arbitrage.
• Improve accountability.
• Reduce compliance costs since firms need deal only with one agency.
• Improve policy coordination, particularly when responding to a crisis.
It is important to tailor the organizational and legal framework to avoid
possible pitfalls (Goodhart and others 1998). Differences between market sec-
tors, due to the types of business they perform and the risks they pose, could
have implications for the efficiency gains anticipated. A unified regulator
might run the risk of becoming too powerful, drifting toward overregulation
unless subject to effective accountability arrangements.
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
262
UNITED KINGDOM
263
CASE STUDIES AND CROSS-COUNTRY REVIEWS
264
UNITED KINGDOM
Risk-based supervision
A guiding principle shaping the operation of the FSA is that similar risks
should be regulated in the same way, regardless of the type of institution reg-
ulated. Under the Financial Services and Markets Act the FSA has introduced
a single enforcement regime applicable to all that it regulates.
The FSA has developed a risk-focused framework to set supervisory pri-
orities. This allows the FSA to focus regulatory resources where the greatest
risks to its statutory objectives lie.
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
266
UNITED KINGDOM
(DMO) was created as an executive agency of the Treasury. It follows the model
of constrained discretion whereby Treasury ministers set the objectives of the
DMO. The agency then exercises discretion to meet those objectives and is
held accountable to Treasury ministers for its actions.
The decision to establish the DMO as an executive agency ensured that it
did not have advance access to government information (except in relation to
the government’s financing needs). This removed any perception that inside
information might influence debt management policy. It also avoided possi-
ble conflicts of interest between debt management and monetary policy deci-
sions. Such conflicts could undermine the DMO’s objective of minimizing
the cost of government financing and of cash management in an open, trans-
parent and predictable way.
The DMO assumed responsibility for the government’s cash manage-
ment in spring 2000. Ensuring that the Treasury is responsible for the gov-
ernment’s cash flows has offered the government an incentive to improve the
accuracy of its cash flow predictions and to optimize the efficiency of those
flows.
The United Kingdom’s debt management practices are fully in line with
the International Monetary Fund (IMF) and World Bank guidelines for pub-
lic debt management. Due to the low level of government indebtedness and
the government’s prudent approach to managing its balance sheet risks, pub-
lic debt management is not a source of vulnerability for the financial system
in the United Kingdom (United Kingdom 2003).
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
The most widely used clearings in value terms are owned and controlled
by their members through the clearing companies under the Association for
Payment Clearing Services.
Securities clearing and settlement systems are supervised by the FSA as
recognized clearinghouses. In the United Kingdom there are now two recog-
nized clearinghouses—the London Clearing House (LCH.Clearnet.Ltd) and
CREST, part of the Euroclear group, which settles equities, corporate bonds,
gilts and money market instruments.
The principle followed throughout the United Kingdom’s payment sys-
tems architecture has been for oversight rather than regulation. Institutional
developments have been market-led rather than driven by legislative or pol-
icy changes. The Bank of England supports improvements to these bodies’
risk management systems, maintains rigorous oversight of payment systems
and reports regularly on its oversight activities.
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UNITED KINGDOM
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
F UTURE REFORMS
The authorities in the United Kingdom have identified areas for further
reform. Some parts of the framework need to be developed to assimilate
changes to international agreements and standards. The FSSA usefully high-
lighted areas where further reform would be desirable.
Insurance supervision
Following publication of the Tiner Report on the Future Regulation of
Insurance (FSA 2001), the FSA has focused on a program of reform that will
overhaul the regulatory regime for insurance companies in the United
Kingdom. Key components of the modernization program include new rules
to determine how much capital insurance companies (both life and general
insurers) have to hold and additional requirements to help ensure they treat
customers fairly. These changes should help improve confidence in the United
Kingdom’s insurance market. The FSA is currently working with industry to
implement the program, which should address the potential weaknesses iden-
tified by the FSSA.
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UNITED KINGDOM
C ONCLUSIONS
Financial stability is an essential prerequisite for realizing the potential bene-
fits of liberalized financial markets. To achieve that stability it is necessary to
have a clear and credible policy framework that facilitates cooperation and
communication among key players—and a regulatory framework that pro-
vides effective and efficient regulation.
Much of what the United Kingdom has learned from its experience of
institutional reform in the financial sector relates specifically to its own con-
text. But some more general lessons can be drawn:
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
N OTES
1. For more information on the mechanics of liberalization and market devel-
opment in the United Kingdom, please see Her Majesty’s Treasury (2003), which
deals in more depth with the United Kingdom’s complementary institutional
reforms to monetary and fiscal policy.
2. There were nine separate predecessor agencies regulating the same area
that the Financial Services Authority now regulates. They were the Investment
Management Regulatory Organization, the Personal Investment Authority, the
Securities and Futures Authority, the Insurance Directorate of the Department of
Trade and Industry, the Bank of England, the Securities and Investments Board,
the Building Societies Commission, the Registry of Friendly Societies and the
Friendly Societies Commission.
3. The United Kingdom has now experienced 49 consecutive quarters of pos-
itive GDP growth.
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UNITED KINGDOM
R EFERENCES
Bank for International Settlements. 2001. “Core Principles for Systematically
Important Payment Systems.” Basel, Switzerland. [www.bis.org/publ/
cpss48.htm].
Bank of England. 2000. “Oversight of Payment Systems.” London. [www
.bankofengland.co.uk/fsr].
———. 2003. “Financial Stability Review.” London. [www.bankofengland.co.uk/
fsr].
FSA (Financial Services Authority). 2001. “The Future Regulation of Insurance.”
Report submitted to the Economic Secretary to the Treasury. London.
[www.fsa.gov. uk/pubs/other/future-reg_insurance.pdf].
Goodhart, Charles, and others. 1998. Financial Regulation: Why, How and Where
Now? London and New York: Routledge.
Her Majesty’s Treasury. 2003. “Macroeconomic Frameworks in the New Global
Economy.” London. [www.hm-treasury.gov.uk/media/B6356/admacro02
-249kb.pdf].
United Kingdom. 2003. “Financial System Stability Assessment Including Reports
on the Observance of Standards and Codes.” London. [www.imf.org/external/
np/fsap].
273
U NITED S TATES
The market for U.S. Treasury securities is a keystone of U.S. financial markets
and a critical component of the global financial system. The market is
extremely large: at the end of 2003 reported daily trading volume was close to
$400 billion, and public holdings had expanded to over $3.5 trillion.1 Treasury
securities are the benchmark for pricing numerous other financial assets, and
they serve as collateral or as the reference asset for a host of transactions in
important related financial markets, including repurchase agreements and
other Treasury-based derivative instruments. Because of the liquidity and
depth of the U.S. Treasury securities market, it is also a key source of infor-
mation about market participants’ reactions to breaking news of the U.S. and
global economy and about views of economic prospects and policy. The
Treasury securities market is also central to the implementation of U.S. fiscal
and monetary policy.
Holdings of U.S. Treasury securities have grown over the last 20 years—
very rapidly until 1997 (figure 1). Federal budget surpluses in the late 1990s
interrupted the trend, but public holdings of U.S. Treasury securities have
been rising once again. Trading volume has increased even more dramatically
in recent years (roughly 20-fold since 1980), and it accelerated even during the
recent pause in the growth of holdings.
U.S. Treasury securities are unencumbered by restrictions on purchase or
sale by nonresidents. As a result, foreign holdings have roughly tripled in size
since 1990, with private and official holders from abroad holding substantial
volumes. Treasury securities are an essential component of effective risk man-
agement for increasingly global portfolios, and for many official holders
changes in their Treasury positions are key to implementing their foreign
exchange policy. The market for U.S. Treasury securities is so globalized that
it is now possible to trade essentially 24 hours a day. Foreign markets appear
to efficiently price new information and developments that occur during U.S.
overnight hours, smoothing the overall market’s operation.
Among foreign countries, Japan stands out with nearly $550 billion in
U.S. Treasury securities, followed by China, where holdings have risen rapidly
in recent years to almost $150 billion.2 The large foreign share of total out-
standings and large concentrations in certain maturities (45 percent in 2003)
has occasionally prompted concern among market analysts about potential
instability if foreign holdings were rapidly sold into a declining market.3 These
worries seem largely unfounded: the Treasury market’s great depth and
274
UNITED STATES
4,000
Total held by public
3,000
2,000
Total foreign (official and private)
1,000
Private foreign
0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2003
liquidity have generally allowed it to absorb brief bouts of heavy foreign sales
without striking increases in volatility or other problems.
The rest of this case study focuses on four structural innovations in the U.S.
Treasury market during the past several decades that were essential to its suc-
cessful development and that allowed it to grow to its current global prominence:
• Treasury note and bond auctions.
• The Federal Reserve’s book-entry system.
• The Federal Reserve’s securities lending program.
• Triparty and General Collateral Finance repos.
These innovations ultimately helped the market for U.S. Treasury securi-
ties function more smoothly and efficiently. But, as the discussion reveals, the
process of identifying the market’s needs and implementing appropriate changes
was not always smooth and direct—a certain amount of trial and error, includ-
ing some failures, is evident from the record. Even so, the story shows how the
U.S. Treasury securities market evolved. It may provide useful lessons for policy-
makers to develop national debt markets and make them more efficient.
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
market and contributed to the Treasury’s ability to finance later deficits. But
it was not obvious in the early 1970s whether auction sales would succeed. The
Treasury had tried in 1935 and 1963 to institutionalize regular auction offer-
ings of long-term bonds, but both attempts failed.
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UNITED STATES
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
278
UNITED STATES
279
CASE STUDIES AND CROSS-COUNTRY REVIEWS
280
UNITED STATES
281
CASE STUDIES AND CROSS-COUNTRY REVIEWS
by daily physical delivery.15 As a result, the arrangement did little to reduce the
need for vault space or coupon clipping.
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UNITED STATES
283
CASE STUDIES AND CROSS-COUNTRY REVIEWS
book-entry system. The Internal Revenue Service soon relaxed its identifica-
tion rule for book-entry securities held for investment purposes and adopted
a new rule facilitating the inclusion of trading account securities in the book-
entry system. In 1971 the FRBNY worked with the Government Securities
Clearing Arrangement banks (thought to be the most vulnerable to the loss
of insurance coverage) to bring dealer securities held for trading purposes
into the book-entry system, a step which allowed FRBNY to acquire critical
experience operating a system with securities of member banks and their cus-
tomers. This also allowed FRBNY to integrate its book-entry system with the
CPD transfer facility at the heart of the Government Securities Clearing
Arrangement. CPD transfers could now be promptly charged to a bank’s book-
entry account, and incoming transfers could be promptly credited, rather than
settled with a physical delivery at the end of the day.16
The expansion of the book-entry system to include all Treasury securities
held by member banks for all of their customers was completed in 1973. As
more and more Treasury securities were converted to book-entry form in the
mid-1970s, the Treasury phased out its definitive issues over 10 years. The
final step in the dematerialization came in August 1986 when the Treasury
implemented a new book-entry system, TreasuryDirect, to accommodate retail
investors. The Treasury then declared that it would no longer issue notes or
bonds in registered form.
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UNITED STATES
Settlement fails
Although most transactions in U.S. Treasury securities settle as originally
scheduled, fails do occur because of miscues and operational problems.
Recognizing this, Treasury market participants allow a failing seller to make
delivery the next business day at an unchanged invoice price. Settlement fails
are not costless, though. The seller loses interest that could have been earned
on the proceeds of the sale while the fail remains uncorrected.19 A fail also
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
exposes both the buyer and the seller to replacement-cost risk if one or the
other becomes insolvent before settlement. The significance of this risk expo-
sure may be small for a fail of only a few days duration, but it increases as a
fail continues. So-called “aged” fails generally prompt market participants to
increase their monitoring of counterparties and sometimes to take more severe
and costly steps.
Fails can be avoided or cured by reversing in (or borrowing directly) the
securities needed for delivery. A market participant is usually better off tak-
ing the prevailing negative specials spread (or paying a borrowing fee) because
the alternative is to fail and forgo interest altogether on the sale proceeds. But
the incentive for a seller to borrow securities to avoid or cure a fail declines
with the specials rate for the security, and market participants may have little
incentive to break a daisy chain when the specials rate for a security is near
zero. This becomes increasingly likely with strong demand for borrowing a
security, such as when short interest in the security is substantial.20
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monetary policy—it was designed to function without affecting the market for
reserve balances. In particular, the Federal Reserve did not lend securities against
borrowing money on repurchase agreements, which would have drained
reserves from the banking system. Instead, dealers had to use other Treasury
securities of comparable value as collateral for their securities borrowings. The
program also limited dealer borrowings in several respects. A dealer could not
borrow more than $50 million face amount of any single bill, more than $10 mil-
lion principal amount of any note or bond or more than $75 million of securi-
ties in aggregate.21 And a dealer had to certify that it was borrowing to replace
securities that a seller had failed to deliver (not to finance a short sale) and that
it had not borrowed the securities elsewhere. The loan fee was set 25 basis points
higher than the 50 basis point fee usually charged by private lenders.
In April 1999, as a consequence of the growth of trading of Treasury secu-
rities during the 1980s and 1990s and the resulting size and complexity of the
securities lending market, the Federal Reserve made some important changes
in its lending program. Dealer limits were increased substantially, and an auc-
tion mechanism was introduced to make loan pricing and security allocation
competitive. The certification requirements were eliminated, but loans were
limited to a single business day to make the program less attractive to dealers
financing short sales for a purpose other than to accommodate customer pur-
chase interests.22
The timing of the daily auctions and how they mesh with the market is
an important feature of the program. At noon on each business day the Federal
Reserve offers to lend up to 65 percent of the amount of each Treasury secu-
rity beneficially owned by the System Open Market Account, up to the amount
of an issue actually in its account. Primary dealers bid for a loan of a specific
security by specifying the quantity desired and a loan fee. The Federal Reserve
imposes a minimum loan fee of 1 percent to deter dealers from borrowing
securities that are not on special and that are readily available from private
lenders. At 12:15 p.m. loans are awarded to the highest bidders at their bid rates
until all the available securities have been allocated or all of the bidders have
been satisfied. Awards are subject to the limitations that a dealer cannot bor-
row more than $200 million of any single issue or more than $1 billion of
securities in total.23
Dealers borrow securities from the Federal Reserve for a number of rea-
sons: to satisfy late-appearing borrowing demands, to reduce their financing
costs and to earn arbitrage profits. Daily over-the-counter trading in securi-
ties loans and special collateral repurchasing agreements remains active until
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
about 10:30 a.m., when liquidity declines as market participants begin to set-
tle the day’s commitments.24 If late in the morning a dealer needs to borrow
a security and cannot locate a seller, the dealer may submit a bid in the Federal
Reserve’s auction, set to occur after the interval of greatest activity in the pri-
vate collateral markets, giving dealers late access to a supplementary source of
securities. Dealers also anticipate auction outcomes when they borrow and
lend collateral earlier in the day. In particular, they try to lend securities at
specials rates lower than those consistent with expected auction loan fees, and
they abstain from borrowing needed securities at such rates. In consequence,
auction activity reflects earlier trading in the specials market as well as late-
appearing borrowing needs. In both respects, the auctions of the Federal
Reserve lending program serve to decrease the incidence of fails.
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well as the class of acceptable collateral. The negotiations take place early in the
day, usually before 10 a.m. Sometime before 11 a.m. the dealer informs the
lender of the specific securities within the agreed-upon class of acceptable col-
lateral that it intends to deliver. The dealer delivers the securities to the lender
against payment of the principal amount of the loan before the 3:30 p.m. close
of Fedwire, the Federal Reserve’s book-entry and securities transfer system. At
the close of the repo, the lender delivers the securities back to the dealer against
repayment of principal and payment of interest at the negotiated rate.
In addition to borrowing funds from institutional lenders to finance secu-
rities positions, some dealers also make two-way markets in general collateral
repurchase agreements, quoting rates at which they are prepared to lend
money as well as rates at which they are prepared to borrow. From time to time
these repo dealers transact among themselves to adjust their net borrowings
and its term structure. This interdealer trading is important because it
enhances the liquidity of the broader repo market. Repo dealers do not nego-
tiate and settle repos directly with their competitors, though. Instead, they use
interdealer brokers to disseminate their bids and offers anonymously, and they
settle their transactions through the interdealer brokers and through the Fixed
Income Clearing Corporation (FICC).25
Settlement of the starting leg of a repo that is arranged by a broker
between two FICC members goes through the broker. The borrowing dealer
delivers its securities to the broker against payment of the principal amount
of the borrowing, and the broker redelivers the securities to the lender against
payment of the same principal amount. This two-step process preserves the
mutual anonymity of the borrower and lender. Settlement of the closing leg
of an interdealer repo goes through the FICC, which nets the settlement oblig-
ations of each party—the borrower, the lender and the broker—with their
other obligations to receive and deliver the same securities on the termination
date of the repo. In a simple case where the borrower and lender have no other
obligations to receive or deliver the same securities on the same day, the lender
delivers the securities that collateralized the repo to the FICC against payment
by the FICC of the principal and interest on the borrowing, and the FICC
delivers the securities to the borrower against payment of the same sum. (The
broker drops out of the settlement process because its obligations net to zero.)
When the borrower or lender has other, off-setting obligations with the same
securities on the same day, settling the closing leg of the repo through the
FICC is less costly than settling through the broker because of the efficiencies
of net settlement.26
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
Triparty repo
As repo financing expanded during the 1980s, market participants began to
appreciate that suppressing collateral specificity could reduce transaction
costs. An important innovation was triparty repurchase agreements, in which
an “agent bank” stands between the borrower and the lender. At the start of a
triparty repo, the dealer delivers collateral—and the lender delivers funds—
to the agent bank. After verifying that the collateral is within the agreed-upon
class with a market value in excess of the loan, the bank releases the funds to
the dealer but continues to hold the collateral, acting as a custodian for the
benefit of the lender. At the end of the repo, the dealer returns the principal
amount of the loan, plus interest at the negotiated rate, to the bank. The bank
releases the collateral back to the dealer, and the bank remits the principal and
interest to the lender. If the dealer fails to repay, the lender can instruct the
bank to sell the collateral to satisfy the lender’s claim on the dealer.
Triparty repo is advantageous in several ways. It reduces the costs of ver-
ifying, valuing and holding collateral because large banks selling custodial
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
enhance liquidity in the interdealer repo market by providing for net settle-
ment and by suppressing collateral specificity in a triparty-like structure.30
Trading in general collateral finance repo starts each morning at about 7:30
a.m. when dealers begin to submit bids and offers to interdealer brokers who
are members of the FICC. When a dealer signals to an interdealer broker that
it is willing to borrow or lend on the terms proposed by another dealer, the
interdealer broker brokering the transaction reports the details of the trade to
the FICC. Trading in general collateral finance repo stops when the securities
Fedwire closes at 3:30 p.m.
At 3:45 p.m. the FICC computes the net obligation of each dealer to lend
or borrow money for one business day or longer as a result of the general col-
lateral finance repo contracts that it negotiated during the day and (as explained
below) the continuing term general collateral finance repo contracts that it
negotiated on earlier days. Each dealer is informed that it is a net borrower and
is obligated to deliver Treasury collateral to the FICC against payment of the
aggregate principal amount of its net borrowing or that it is a net lender and
is obligated to receive Treasury collateral against payment of the aggregate prin-
cipal amount of its net loan. A dealer that clears through JPMorgan Chase
Bank, for example, and is a net borrower on general collateral finance repo on
all Treasury issues has until 4:30 p.m. to transfer Treasury bills, notes or bonds
of its choosing to an FICC account at JPMorgan Chase Bank against payment
of the principal amount of its net borrowing. JPMorgan Chase Bank is respon-
sible for verifying that the securities are U.S. Treasury securities and have a
market value not less than the principal amount of the dealer’s net borrowing.
The dealer does not have to identify the securities that it intends to deliver prior
to actual delivery, so its delivery option survives well past the time when col-
lateral is assigned for delivery-versus-pay repos. The securities transferred to
the FICC account are redelivered to other dealers who also clear through
JPMorgan Chase Bank and who are net lenders against payment of the prin-
cipal amounts of their respective net loans. The transfers of securities from net
borrowers to the FICC’s account at JPMorgan Chase Bank, and the transfers
of securities from two FICC accounts to net lenders occur entirely on the books
of JPMorgan Chase Bank and do not require any Fedwire transfers.31
All the foregoing deliveries and payments are reversed the next morning
before the opening of the securities Fedwire. Borrowed funds are returned to
lenders and collateral securities are returned to borrowers. If a market partic-
ipant is committed to borrow or lend on a continuing general collateral
finance repo, its commitment is reinstated by the FICC immediately following
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N OTES
1. This figure includes foreign official holdings.
2. These estimates are for holdings at the end of December 2003. Hong Kong
(China) holds another large share, close to $60 billion; Taiwan (China) and the
Republic of Korea are prominent as well. Not surprisingly, given that it is the
location of a major global financial center, holdings reported for the United
Kingdom, about $115 billion, make up another very large portion.
3. Foreign residents hold U.S. Treasury securities in somewhat different pro-
portions across maturities. They tend to favor longer-term issues and hold rela-
tively fewer bills. That preference has become somewhat more pronounced in
recent years.
4. Faced with the prospect of an undersubscribed offering, officials some-
times pressured banks and dealers to take up the slack.
5. In addition, in a practice known as “free-riding”, some market partici-
pants, after subscribing for new issues, sought to sell their allotments quickly at a
premium. This practice was widely criticized for hindering direct sales of new
issues to final investors and was believed to contribute to price volatility.
6. Conversely, setting overly generous terms on an exchange offer could cause
the maturing securities in the exchange to trade at a negative yield.
7. Including, prominently, from economist Milton Friedman.
8. This restriction had been in effect since the first auction of Treasury notes
in 1970. (When-issued trading had not been restricted for bills.) The Treasury re-
imposed the restriction on pre-auction when-issued trading of notes and bonds
in July 1977, but removed the restriction again in August 1981, characterizing it
as interfering with efficient adjustment of market prices.
9. Since 1916 the Treasury has used the 12 district Federal Reserve banks as
its fiscal agents. The agency functions of the Reserve banks include accepting,
holding, transferring and paying out government deposits; making interest pay-
ments on government debt; issuing and redeeming government debt; providing
for denominational exchanges of government debt; and safekeeping collateral
pledged against government monies held by private depositary institutions.
10. The Treasury would replace a lost or stolen bearer bond, but not until it
had matured and time had passed to allow the bond to be presented for payment.
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
11. Treasury bills were never available in registered form because there was
so little demand for a short-term security that could not be transferred quickly.
12. The terminology derives from the fact that before 1941 the Commissioner
of Public Debt (CPD) had to be notified of and approve every wire transfer of a
Treasury security.
13. The new arrangement was prompted in part by the fact that CPD trans-
fers had become an increasingly large and expensive part of NYFRB operations.
14. FRBNY made end-of-day deliveries to banks with a credit balance by
drawing on the inventory of bearer securities that it held as a fiscal agent of the
Treasury. A bank with an obligation to deliver securities to FRBNY was essentially
running an overdraft in its securities account at FRBNY. A bank had to agree that
as long as it ran an overdraft in a security it would retain possession of enough of
that security in bearer form to settle the overdraft.
15. If a bank failed to deliver securities required to settle its position at the
end of a business day, FRBNY could charge the bank’s reserve account for the
principal amount of the securities. If the bank failed to deliver the securities on
the following business day as well, FRBNY could “buy in” the securities and charge
the bank for the cost of the buy-in. Additionally, each participant in the
Government Securities Clearing Arrangement was obliged to indemnify FRBNY
for any loss arising from a settlement failure of another participant.
16. The Government Securities Clearing Arrangement eventually was termi-
nated in December 1977 after securities transfers were integrated into the book-
entry system.
17. The counterparty in such a case—often an institutional investor with
large holdings of Treasury securities—executes a repurchase agreement, lending
securities and borrowing money.
18. Market participants also can borrow Treasury securities by pledging col-
lateral and paying a fee to a lender—an arrangement that accommodates securi-
ties lenders such as some institutional investors who are not allowed to borrow
money. The fee is typically about the same as the contemporaneous specialness
spread for the security.
19. This cost may be reimbursed by the buyer, if the buyer’s actions caused
the fail, or by a third party, if the third party’s actions caused the fail.
20. Such short interest usually is concentrated in highly liquid on-the-run issues.
This suggests why specials rates fall for on-the-run 5- and 10-year notes and fails rise
around mid-quarter refunding auctions, when market participants are actively
engaged in taking positions based on their assessments of the relative values of dif-
ferent securities and the prospect for change in the level and shape of the yield curve.
21. The lending limits were suspended briefly when Drysdale Government
Securities Inc. failed in May 1982, when Hurricane Gloria disrupted New York
financial markets in 1985 and after the break in the stock market in 1987.
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UNITED STATES
22. Short sales to accommodate customer purchase interests are usually cov-
ered within a day or two and are commonly financed with overnight borrowings.
Short sales executed as a hedge or as part of a spread trade are commonly financed
with open or term borrowings.
23. Each participating dealer is told within minutes of the auction close which
of its bids were accepted and which were rejected. The Federal Reserve also pub-
licly announces the total amount lent of each security and the weighted-average
loan fee for each security.
24. The late morning decline in liquidity became more pronounced during
the second half of the 1990s, when dealers began financing their long and short
positions earlier in the day following the imposition in 1994 by the Federal Reserve
of charges for daylight overdrafts in the reserve accounts of depository institutions
and the prospect that dealer clearing banks would pass on such charges to their
customers. This prompted the Federal Reserve to advance the time at which it
enters the market to supply reserves to the banking system by lending on overnight
repos (from about 11:30 a.m. prior to 1997 to about 9:30 a.m. now).
25. The FICC is a wholly owned subsidiary of the Depository Trust and
Clearing Corporation (DTCC), which also owns the Depository Trust Company.
The Government Securities Division of the FICC is the successor to the
Government Securities Clearing Corporation (GSCC), which was acquired by the
DTCC in January 2002. The GSCC was organized in the late 1980s to simplify
the settlement process for U.S. Treasury and federal agency securities, to reduce
the volume of Fedwire transfers and to mitigate risk arising from counterparty
exposures in the government securities market.
26. The starting leg of the repo is not settled through the FICC because, out-
side of the general collateral finance repo facility, the FICC does not provide for
net settlement of transactions that settle on the day they are negotiated.
27. A borrower has to identify a particular security so the lender can instruct
its custodian to accept delivery of the security and to make the required payment
and because the lender subsequently holds that particular security during the term
of the repo.
28. Bids and offers for money on term general collateral repos commonly
provide that the borrower has an option to substitute collateral a specified num-
ber of times during the life of the borrowing. Interest rates on contracts for a
given term are higher the greater the number of allowed substitutions to com-
pensate lenders for the prospect of greater future settlement expenses.
29. The clearing bank finances any unallocated collateral, at a rate above the
contemporaneous general collateral repo rate, as part of its clearing relationship
with the dealer. Minimizing the amount of unallocated collateral also minimizes
the dealer’s aggregate financing costs.
30. The FICC sponsors general collateral finance repo trading in five collat-
eral classes including all Treasury bills, notes and bonds. Dealers that clear through
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
JPMorgan Chase Bank can trade general collateral finance repo only with other
dealers that trade through JPMorgan Chase Bank; likewise, dealers that clear
through Bank of New York, only with other dealers that clear through Bank of
New York.
31. The aggregate net borrowing of all dealers who are net borrowers and
clear through JPMorgan Chase Bank is identical to the aggregate net loan of all
dealers who are net lenders and clear through JPMorgan Chase Bank, because
every general collateral finance repo transaction involves a borrowing and a loan
of identical size by dealers who clear through the same bank. Thus, the total pay-
ments received by the FICC in its JPMorgan Chase Bank account equal the total
payments disbursed by JPMorgan Chase Bank.
32. In addition, there are daily accrued interest and mark-to-market pay-
ments associated with the reversals to limit credit exposures. To preserve the con-
vention that interest on general collateral finance repo is paid in full at maturity,
both of the foregoing payments are returned the following day with interest at the
overnight repo rate.
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E UROPEAN U NION
Institutions establish the rules of the game for an economy, the formal and
informal “constraints that structure political, economic and social interac-
tions” (North 1991). They can be viewed as establishing an incentive structure
that reduces transaction uncertainty and promotes efficiency in the market.
Indeed, there is fairly strong evidence linking well functioning institutions
and good governance to positive economic and social outcomes and financial
system development and stability. Indeed, institutional factors appear to be
more important than productive factor endowments or any other explanations
in determining cross-country differences in the overall level of development.1
Based on this broad definition, EU integration itself can be viewed as an
institution-building process. The European Community created a unique sys-
tem of governing institutions designed to create a single internal market for
goods, services and capital and, to do so, was empowered to adopt legislation
binding all member states. Today, EU legislation covers an ever broader range
of areas, including not only trade, economic affairs and financial services, but
also energy, environment, consumer protection, competition and consumer
policies.
Through regulation, EU integration has provided a broadly harmonized
incentive structure for the economies of all member states. In many ways it rep-
resents a “commitment device” that affects performance primarily by fostering
better policy choices and institutions at the national level. The EU institutional
framework could be regarded as an “external anchor” that puts policymakers
under continuing pressure to promote better domestic institutions.
The EU institutional framework defines a set of minimum regulatory
requirements that should be applied by all member states (thus harmonizing
national regulations), while enforcing the mutual recognition of regulatory
measures. Mutual recognition implies that legal acts such as the authorization
of a bank to operate or the authorization of a fixed-income security prospec-
tus valid in one member state under its legislation become valid in all member
states. Mutual recognition therefore allows the bank authorized to operate in
one member state to operate across the European Union or the bond autho-
rized to be sold by one securities regulator to be marketed to investors across
the European Union. Mutual recognition implies that market activity will shift
to the member state with the best regulatory environment, creating competi-
tion among member states. Institutions thus tend to rise to the level of best
practice either through regulatory harmonization or through competition
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
298
EUROPEAN UNION
steps are rooted in the relevant fundamental provisions of the Treaty of Rome
signed in 1957, which sought to transform Europe’s highly segmented national
markets into a common market.2
But, the Treaty of Rome did not call for a complete liberalization of cap-
ital movements. Capital mobility was fostered only to the extent that would
be required for the proper functioning of the single market and the free move-
ment of persons, goods and services. Thus, greater financial integration was
for many years impeded by severe restrictions on capital mobility. The process
of further integration gained momentum only in the early 1980s, at a time of
stagnating internal growth and deteriorating external competitiveness. At the
same time, this momentum was made possible because decades of European
integration had provided the institutional and political critical mass to
progress one step further.
European integration has been characterized by a strong institutional
component consisting of several layers. At the political level, member states
have to fulfill minimum common requirements, which at the same time are
key conditions for developing and maintaining a stable financial system—
such as a democratic constitutional system and respect for the rule of law. In
the economic area the EU institutional framework includes features that are
also important building blocks of well functioning financial markets, such as
the independence of central banks.
For the legal and regulatory underpinnings, supervisory and regulatory
arrangements have been based on the principles of minimal harmonization
and mutual recognition. Mutual trust and policy cooperation among EU
members states have been crucial in developing an institutional setting with
a sound legal basis. This allowed legislative power to be pooled among supra-
national EU institutions and national governments and the mutual recogni-
tion of national laws to be accepted as an institution-building principle.
Membership in the European Union requires adherence to the whole set
of legal and institutional provisions built up by the European Union over time.
As stated in the Treaty on European Union, any European State that respects
the principles of liberty, democracy, respect for human rights and fundamental
freedoms, as well as the rule of law, may apply to become a member of the
European Union. The Copenhagen European Council in June 1993 marked
the political start of the current enlargement process by defining criteria that
applicant countries should meet as pre-conditions to becoming members of
the European Union.3 The Copenhagen criteria require the stability of insti-
tutions guaranteeing democracy, the rule of law, the respect of human rights
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
300
EUROPEAN UNION
to regulation and supervision of the authority that has issued that license
(“home country principle”). The authority had to comply with some minimum
legislative requirements common to all European Union member states. Thus,
an investment firm authorized to operate in France and supervised by the French
regulator under French law (partially harmonized with those of the other mem-
ber states) would be able to operate across the whole European Union. This
implied that financial institutions subject to partly different regulatory and
supervisory settings would compete in the same European market.
This integration strategy also implied the introduction of qualified major-
ity voting (instead of unanimity) to approve regulations for a large number
of legislative fields at the EU level. EU legislation approved by qualified major-
ity voting—and thus with the possible opposition of some member states—
was then incorporated into the domestic regulations of all EU member states
regardless of whether they had voted in favor.
The Single Market Programme formed the legal framework for the free cir-
culation of capital and stipulated the removal of all barriers to the provision of
cross-border financial services and to the right of establishment (that is, the right
of a person or business to carry out business in any member state). With the
increased relevance of cross-border activities, a market-driven process of regu-
latory competition took place—an important tool to prevent the adoption of
unnecessarily cumbersome regulations and to select the best supervisory prac-
tices. At the same time, the minimum common standards set a floor to regula-
tory competition, preventing the adoption of lax regulation to attract business.
The regulation of prospectuses is a good example of how this mechanism
works. Under EU regulation, issuers of debt securities may have their prospec-
tus approved by any national EU securities regulator, not necessarily that of
their home country. At the same time, all securities regulators must enforce a
common prospectus regulation. To make effective a system in which several
national authorities are jointly responsible for an integrating market, the Single
Market Programme also envisaged a substantial development of cooperation
among competent national authorities, including improved exchanges of infor-
mation among them.
The Single Market Programme was also instrumental in supporting
domestic financial reform efforts toward deregulation, thus increasing the level
of competition and contributing to a first wave of consolidation in national
banking markets. This enhanced the positive impact of the dismantling of
cross-border barriers on banking sector development. Overall, the Single
Market Programme considerably expanded the scope and the competitiveness
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
302
EUROPEAN UNION
budget policies after the introduction of the euro. In addition, the prohibition
of bailing out public debt through the Community or another member state,
which is provided for in the treaty, was considered to be potentially insuffi-
cient to guarantee fiscal discipline over time.
The economic rationale for the rules-based approach embedded in the
Maastricht criteria for fiscal policies and the Stability and Growth Pact stems
from historical experience. Excessive public deficits had led to crowding out
of private sector issuers from the debt markets, strains on the exchange rate
and financial sector vulnerabilities given potential overexposure of investors
and the banking system to unsustainable government debt.
Moreover, the need for fiscal discipline and for fiscal rules was likely to be
greater in a monetary union. First, given the loss of national monetary and
exchange rate policies, fiscal policies need to be on a sound footing in order
to be in a position to cushion the effects of country specific shocks. Second,
the incentive to pursue sound fiscal policies may be weaker in a monetary
union because a country may enjoy short-term benefits from a relaxation of
its fiscal policy while the negative consequences for the level of interest rates
and the exchange rate are spread across all member countries.
Further provisions of the treaty have a bearing on the working of European
financial markets. Some of these provisions have had to be respected since the
second stage of the EMU (starting 1 January 1994) and had to be complied with
by acceding countries from the time of accession (on 1 May 2004 for the 10 new
member states). These include:
• The prohibition of monetary financing of the public sector by the
ECB or national central banks, which implies that no credit facilities
may be granted to EU institutions, central governments or public
undertakings, and that no public debt instruments may be directly
purchased by the ECB or the national central banks.
• The prohibition of the privileged access of the public sector to finan-
cial institutions.
• The establishment of central bank independence. Members of the
decisionmaking bodies of the ECB and national central banks shall
neither seek nor take instructions from any other outside bodies, such
as Community institutions or national governments. The treaty’s
requirement for central bank independence reflects the view that the
achievement of price stability is best served by an institution whose
independence is limited only by the need for transparency and
accountability and by the precise definition of its mandate.
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
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EUROPEAN UNION
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
for some years based their asset allocation strategies on industry and
sector considerations, not on national considerations.10
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EUROPEAN UNION
European financial system. The Lisbon European Council in 2000 and the
Stockholm European Council in 2001, which established the guiding princi-
ples and objectives of European structural reforms, reaffirmed the importance
of completing the internal market for financial services as an important ele-
ment in ensuring a vibrant European economy. In this context, a deadline for
full implementation of the Financial Services Action Plan was set, in the Lisbon
European Council, for 2005.
Another important area of recent financial institution building designed
to contribute to EU financial market integration was the major overhaul of the
European Union’s legislative techniques, as proposed by the Committee of Wise
Men in February 2001.11 This took place against the background of growing
concerns that the European Union’s legislative decisionmaking process was too
slow and burdensome, that it was too inflexible to keep up with market devel-
opments and that the implementation of harmonized rules across member
states was not sufficiently consistent.
The “Lamfalussy report”, named after the chairman of the Committee of
Wise Men, proposed a new framework for the regulation of the securities mar-
ket, distinguishing four levels of financial legislation and implementation.
• At level 1 the basic policy principles and objectives of the legislation,
which are expected to remain relatively stable over time, would be
laid down via the normal EU legislative process requiring approval by
the European Parliament and the Council.
• At level 2 implementing measures for level 1 legislation would be
adopted by the European Securities Committee composed of senior
member state representatives on the basis of a text proposed by the
European Commission. The commission will chair the committee
and provide its secretariat but will not vote. Level 2 legislation will
include technical measures that will need to keep in step with mar-
ket and supervisory developments. The process would benefit from
the input of a special regulatory committee, comprising the relevant
national and European authorities.
• Level 3 would encompass initiatives by national supervisors designed
to ensure a more consistent and timely implementation of legislation
at the national level. A committee of supervisors would assist in this
process. For the securities field the Committee of European Securities
Supervisors was established in Paris. For banking the Committee of
European Banking Supervisors was established in London in 2004.
The Committee of European Insurance and Occupational Pension
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
P OLICY IMPLICATIONS
To what extent has globalization been a driving force behind institution build-
ing? And how can institution building help contain potential risks of global-
ization? Although the EU experience is a unique case of institution building
stretching over several decades, it can provide some relevant answers to both
questions. First, EU integration can be seen as a globalization process that has
been faster and with broader scope at the regional level than at the world level.
Second, EU countries have adopted an approach to regional integration with
a strong institutional component.
EU integration through harmonization and mutual recognition has
prompted a learning process among member states about best practices, gen-
erating momentum for continuous improvement of institutions. This process
has provided benchmarks and speeded institutional reforms in individual mem-
ber states, especially those at the periphery of the European Union, where finan-
cial development was initially lagging behind. This approach is to some extent
comparable with the standards and codes initiatives promoted by the interna-
tional financial community, which define internationally accepted best prac-
tices in various areas. But there is a major difference between the two approaches.
EU standards are legally binding and overrule national law, while international
standards and codes have to be adhered to on a best-effort basis.
The EU experience shows that financial integration on a regional level—
based on the principles of private sector competition, regulatory best practice
310
EUROPEAN UNION
311
CASE STUDIES AND CROSS-COUNTRY REVIEWS
N OTES
1. See, for example, Acemoglu (2003).
2. Treaty establishing the European Economic Community (1957).
3. Enlargement was originally the term used to refer to the four successive
waves of new members joining the European Community. Nine countries have
so far joined the six founder members—Belgium, France, Germany, Italy,
Luxembourg and the Netherlands—at the following dates: Denmark, Ireland and
the United Kingdom in1973; Greece in 1981; Portugal and Spain in 1986; Austria,
Finland and Sweden in 1995. The current wave of accessions has turned enlarge-
ment into a unique opportunity to bring peace, stability and prosperity to the
entire continent of Europe. It is an unprecedented enlargement in terms of its
dimension and diversity. As of 1 May 2004, 10 countries from Central and Eastern
Europe—the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slo-
vakia and Slovenia—as well as two Mediterranean countries—Malta and
Cyprus—have joined the EU. As far as Bulgaria and Romania are concerned, the
goal is to enable them to join by 2007. Negotiations might be opened with Turkey
in 2005 if the country has fulfilled the political part of the Copenhagen criteria (see
http://europa.eu.int/scadplus/leg/en/cig/g4000a.htm#a11).
4. The acquis is the body of common rights and obligations that bind all the
member states together within the European Union. It is constantly evolving and
comprises: the treaties, Community legislation, the case law of the Court of Justice,
the declarations and resolutions adopted by the Union, measures relating to the
common foreign and security policy and to justice and home affairs and interna-
tional agreements concluded by the Community and by the member states
between themselves in the field of the Union’s activities (see http://www.europa
.eu.int/scadplus/leg/en/cig/g4000c.htm#c16a).
5. The general rule of mutual recognition was established by the European
Court of Justice in its Cassis de Dijon judgment 1979, providing that goods law-
fully manufactured and marketed in one member state must be allowed free entry
into other member states, unless restrictions are necessary in order to satisfy
mandatory requirements (for example, the effectiveness of fiscal administration,
the protection of public health, the fairness of commercial transactions, consumer
protection and environmental protection). Harmonization henceforth would
focus on minimum requirements; compliance with the latter would entitle a prod-
uct to free movement within the Community.
6. All the EU countries except for Denmark, Greece, Sweden and the United
Kingdom. While Denmark, Sweden and the United Kingdom decided for political
reasons not to join the EMU at this point, Greece was unable to join as it did not
312
EUROPEAN UNION
meet all the convergence criteria. On 1 January 2001 the euro was introduced in
Greece, following a report by the ECB and the EU Commission that Greece had then
fulfilled all the necessary requirements.
7. The basic tasks of the Eurosystem are to define and implement the mon-
etary policy of the euro area, to conduct foreign exchange operations, to hold and
manage the official foreign reserves of the euro area member states and to pro-
mote the smooth operation of payment systems.
8. Moreover, the treaty envisages the possibility of conferring specific tasks
to the ECB in the area of prudential supervision of credit institutions and other
financial institutions with the exception of insurance undertakings. This option
has, however, so far not been used.
9. Financial development can affect growth through three channels: it can
raise the proportion of savings channelled to investment through the reduction
of the costs of financial intermediation, it can improve the allocation of resources
across investment projects, thus increasing the social marginal productivity of
capital, and it can influence households’ saving rate. While in the first two cases
the effect on growth is generally positive, in the third the direction of the effect is
ambiguous (Pagano 1993).
10. See European Central Bank (2001).
11. See Committee of Wise Men on the Regulation of European Securities
Markets (2001).
R EFERENCES
Acemoglu, D. 2003. “Root Causes—A Historical Approach to Assessing the Role
of Institutions in Economic Development.” Finance and Development 40 (22):
27–30.
Adjaouté, K., and J.-P. Danthine. 2003. “European Financial Integration and
Equity Returns: A Theory-Based Assessment.” In V. Gaspar, P. Hartmann,
and O. Sleijpen, eds., The Transformation of the European Financial System,
Proceedings of the Second ECB Central Banking Conference. Frankfurt,
Germany: European Central Bank.
Baele, L., A. Ferrando, P. Hordahl, E. Krylova, and C. Monnet. 2004. “Measuring
Financial Integration in the Euro Area.” Occasional Paper 14. European
Central Bank, Frankfurt, Germany.
Barr, D.G., and R. Priestley. 2002. “Expected Returns, Risk and the Integration of
International Bond Markets.” Journal of International Money and Finance
23(1): 71–97.
Committee of Wise Men on the Regulation of Securities Markets. 2001. “Final
Report of the Committee of Wise Men on the Regulation of Securities
Markets.” Council of the European Union, Stockholm.
313
CASE STUDIES AND CROSS-COUNTRY REVIEWS
De Avila, D.R. 2003. “Finance and Growth in the EU: New Evidence from the
Liberalization and Harmonization of the Banking Industry.” ECB Working
Paper 266. European Central Bank, Frankfurt, Germany.
Devereux, M., and G. Smith. 1994. “International Risk Sharing and Economic
Growth.” International Economic Review 35(3): 535–50.
Duisenberg, W. 2000. “The Euro as a Catalyst for Legal Convergence in Europe.”
Address at the Annual Conference of the International Bar Association, 17
September, Amsterdam.
European Central Bank. 2001. “The Euro Equity Market.” Frankfurt, Germany.
———. 2003. “The Integration of the European Financial Markets.” Monthly
Bulletin, October. Frankfurt, Germany.
EU Commission. 2001. “Financial Market Integration in the EU.” In The EU
Economy Review. Brussels. [http://europa.eu.int/comm/economy_finance/
publications/european_economy/2001].
———. 2003. “Tracking EU Financial Integration.” Commission Staff Working
Paper SEC(2003) 628. Brussels. [http://europa.eu.int/comm/internal_
market/en/finances/cross-sector].
Favero, C.A., A. Missale, and G. Piga. 2000. “EMU and Public Debt Management:
One Money, One Debt?” CEPR Policy Paper 3. Centre for Economic Policy
Research, London.
Galati, G., and K. Tsatsaronis. 2001. “The Impact of the Euro on Europe’s Finan-
cial Markets.” BIS Working Paper 100. Bank for International Settlements,
Basel, Switzerland.
Giannetti M., L. Guiso, T. Iappelli, and M. Pagano M. 2002. “Financial Develop-
ment, Corporate finance and growth.” Economic Paper 179. European Com-
mission, Brussels. [http://europa.eu.int/comm/economy_finance/publications/
economic_papers/economicpapers179_en.htm].
Hartmann, P., A. Maddaloni, and S. Manganelli. 2003. “The Euro Area Financial
System: Structure, Integration and Policy Initiatives.” Oxford Review of
Economic Policy 19 (1): 180–213.
Hentschel, L., J. Kang, and J.B. Long. 2002. “Numeraire Portfolio Tests of Inter-
national Government Bond Market Integration and Redundancy.”
[www.ssb.rochester.edu/fac/Hentschel].
North, D.C. 1991. “Institutions.” Journal of Economic Perspectives 5: 97–112.
Pagano, M. 1993. “Financial Markets and Growth: An Overview.” European
Economic Review 37 (2–3): 613–22.
Pelkmans, J. 1997. European Integration—Methods and Economic Analysis. Oxford,
U.K.: Oxford University Press.
314
F INANCIAL S ECTOR S TANDARDS
AND C ODES AND I NSTITUTION
B UILDING
P REPARED BY THE I NTERNATIONAL M ONETARY F UND
315
CASE STUDIES AND CROSS-COUNTRY REVIEWS
316
FINANCIAL SECTOR STANDARDS AND CODES AND INSTITUTION BUILDING
317
CASE STUDIES AND CROSS-COUNTRY REVIEWS
the medium term. A 2002 outreach meeting with officials from countries that
had participated in FSAPs identified several benefits of the FSAP assessments,
including the application of a comprehensive approach to analyzing financial
sector issues, an independent and objective review by outsiders and an inter-
active dialogue with experts from other countries that allowed for compari-
son of practices.
Standard assessments often jump-started reform efforts and helped
sharpen or redirect their focus. Some countries established a special commit-
tee to follow up on FSAP recommendations and strengthen national owner-
ship of their implementation. These examples highlight how assessments have
promoted internal dialogue and mobilized political support for reform.
Standards assessments have also helped country authorities compare the
transparency of their policies and practices with international benchmarks.
The dissemination of transparency standards worldwide has raised interest in
observing them. The IMF’s Financial System Stability Assessments and other
FSAP documents, such as the Reports on Observance of Standards and Codes,
detailed standards assessments and analysis of selected issues, also increase
transparency and economic agents’ knowledge of countries’ financial sectors,
especially monetary and financial policies and regulatory and supervisory
frameworks. This should help country leaders improve policy discipline, make
better decisions and operate more efficient markets and institutions.
318
FINANCIAL SECTOR STANDARDS AND CODES AND INSTITUTION BUILDING
319
CASE STUDIES AND CROSS-COUNTRY REVIEWS
guarantees). More liberalized and competitive insurance markets are also pos-
ing new and increasingly complex challenges for supervisory authorities.
Assessments of the International Organization of Securities Commis-
sions’ principles have revealed several weaknesses in the regulation and super-
vision of securities markets in many countries. These include:
• Limited resources for supervisory authorities.
• Diffusion of regulatory responsibilities across several agencies and
unclear roles for those agencies.
• Lack of independence for the regulator, including in budgetary
allocations.
• Inability to enforce compliance with the law and administer penalties.
• Inadequate sharing of information among domestic regulatory bodies.
• Lack of adequate power or administrative capacity to prevent
prospectuses that do not meet minimum information requirements.
• Inadequate and lack of timely disclosure of information.
• Weak provisions for protecting minority shareholder interests.
• Ineffectiveness in ensuring appropriate financial reporting and cor-
porate disclosure.
• Inadequate regulation of intermediaries’ risk management and inter-
nal organization, capital adequacy and other prudential controls and
procedures in the event of failure.
• Weakness in detecting and prosecuting manipulation and other
unfair trading practices.
• Inadequate oversight of clearing and settlement systems.
Assessments of the IMF’s Monetary and Financial Policies Transparency Code
have underscored concerns in many countries (box 1). Recommendations to
address these have focused on the content and forms of disclosure. Better disclo-
sure and explanation of the monetary policy analysis, framework and procedures
are needed, along with more public consultations on proposed technical changes
to monetary regulations. The focus of financial policy has been on information
sharing, frequency of data reporting by financial agencies and greater transparency
of relationships among financial agencies. Achieving greater accountability and
integrity of monetary and financial institutions was also emphasized. In response
to the assessments, some authorities have taken steps to increase transparency,
which should help strengthen market and policy discipline.
While most assessed countries have adopted some Anti-Money Launder-
ing and Combating Financing of Terrorism measures, there is considerable
variation among systems and, in many countries (and most developing and
320
FINANCIAL SECTOR STANDARDS AND CODES AND INSTITUTION BUILDING
B OX 1
321
CASE STUDIES AND CROSS-COUNTRY REVIEWS
B OX 1 C ONTINUED
Russia
Monetary policy. The 1999 annual financial statement was published
with more detailed information on the relationship between the Bank
of Russia and the Ministry of Finance, central bank income and
expenditure and new information on its capital, funds and profit dis-
tribution. The most important measure was preparing the annual
financial statement in compliance with international standards.
Precious metals transactions and government securities, however, are
still valued at acquisition cost.
322
FINANCIAL SECTOR STANDARDS AND CODES AND INSTITUTION BUILDING
regulation, assistance has been somewhat limited, but the growing importance of
related development needs emerging from FSAP assessments may increase this.
For payment systems, technical assistance has covered operation of real-time gross
settlement systems (for example, queuing of payments, payment message types
and central bank intraday lending to participants), as well as broader payment sys-
tem reform involving large-value and retail payment systems. For banking super-
vision, the demand for follow-up technical assistance remains high, with varied
focus. For Anti-Money Laundering and Combating Financing of Terrorism, coun-
tries have requested technical assistance on legislative drafting, review and imple-
mentation (especially with respect to financing terrorism), capacity building and
training in the financia1 sector. Regional projects are being used to reach a large
number of countries. A Web-based database for sharing information on techni-
cal assistance requests and responses is used by FATF-style regional bodies, the
World Bank and the IMF to identify technical assistance needs. Further follow-
up with donors is planned to ensure that identified needs are addressed.
The IMF intends to continue supporting its members with technical assis-
tance for addressing financial stability and developmental concerns. It will also
work toward updating financial sector standards. Technical assistance priorities
based on FSAP findings are being incorporated more systematically in the World
Bank and IMF’s overall technical assistance programs. Mechanisms have also been
set up for improved and more systematic follow-up on technical assistance needs
identified in FSAP and Reports on Observance of Standards and Codes processes.
One response is the Financial Sector Reform and Strengthening initiative—a
multidonor partnership jointly undertaken by the World Bank, the IMF and
national development agencies, that established a trust fund to supplement World
Bank and IMF technical assistance, to decide on the criteria, allocation and pri-
orities and to supervise and implement the technical assistance financed by the
trust fund.6 In doing so, the initiative also helps to improve coordination of finan-
cial sector technical assistance between the World Bank, the IMF and other donors.
323
CASE STUDIES AND CROSS-COUNTRY REVIEWS
securities areas to reinforce the internal review process by enlarging the pool
of available reviewers, who are generally drawn from cooperating institutions.
The IMF and World Bank staff helped complete the joint forum on com-
parison of banking, insurance and securities core principles. IMF and World
Bank staff have also worked with standards setters to review methodologies
based on assessment experiences that provide crucial feedback on the use of
the codes and standards.
The IMF and World Bank staff will continue working on issues relating
to standards assessments, including:
• The appropriate scope and coverage of assessments.
• Ways to account for country-specific factors based on their relative
significance, depending on stages of development, sector-specific vul-
nerabilities and the regulatory and supervisory preconditions.
• Identification of cross-sector issues and interdependencies between
standards.
• Circumstances in which assessment of observance of a particular
standard might not be warranted.
• More structured approaches to assessing the preconditions for effec-
tive supervision.
N OTES
1. See Prasad and others (2003).
2. This note mainly draws on Calari and Ingves (2003).
3. See IMF (2004).
4. Financial stability is measured as the average of the capital adequacy ratio
and the ratio of nonperforming loans to total loans.
5. See IMF (2003).
6. For details, see Calari and Ingves (2003).
R EFERENCES
Calari, C., and S. Ingves. 2003. “Financial Sector Assessment Program—Review,
Lessons, and Issues Going Forward.” Including supplements. IMF Working
Paper SM/03/77. International Monetary Fund, Washington, D.C.
Das, Udaibir S., Marc Quintyn, and Kina Chenard. 2004. “Does Regulatory Gov-
ernance Matter for Financial System Stability? An Empirical Analysis.” IMF
Working Paper 04/89. International Monetary Fund, Washington, D.C.
IMF (International Monetary Fund). 2003. “Growth and Institutions,” In World
Economic Outlook. International Monetary Fund, Washington, D.C.
324
FINANCIAL SECTOR STANDARDS AND CODES AND INSTITUTION BUILDING
325
T HE E VOLVING I NSTITUTIONAL
AGENDA FOR S OUND F INANCE
P REPARED BY THE W ORLD B ANK
The last decade saw path-breaking research that demonstrated the impor-
tance of a sound financial sector for economic growth and poverty allevia-
tion. This work highlighted the role of finance in mobilizing savings and
allocating credit, as well as for a variety of risk transfer and mitigation func-
tions. From a better understanding of these functions, it is now clear that the
financial sector is not just about “money”, but rather it encompasses a vari-
ety of components: buyers and sellers of a potentially wide range of finan-
cial services, official regulators and supervisors, markets that monitor
intermediaries, and a complex web of customs, laws and the information and
judicial systems, all of which are essential to make finance work well. This
web is so large because of the nature of finance: entering into a contract that
usually entails surrendering control of financial resources at a point in time,
with the conditional or unconditional promise or expectation of redemp-
tion, usually with some positive return, in the future. Thus it is difficult to
conceive of finance without taking account of the supporting institutions on
which its existence depends.
Unfortunately, when developing countries began to liberalize their finan-
cial systems in the late 1970s and early 1980s, the important role of the sup-
porting infrastructure and the institutional framework for the financial sector
was not appreciated. As result, countries often adopted “stroke-of-the-pen”
reforms, such as interest rate liberalization and more recently the imposition
of explicit deposit insurance schemes. These reforms were cheap, quick and
easy to implement in contrast with the institution building steps, usually
expensive, slow and difficult to put in place. As a result, many liberalization
efforts were followed by often expensive financial crises. These crises, along
with broader concerns about the limited success with growth and poverty alle-
viation, have led to a re-examination both in finance and in the broader eco-
nomic development literature. At the same time, the rise of the new
institutional economics and the creation of databases on different aspects of
326
THE EVOLVING INSTITUTIONAL AGENDA FOR SOUND FINANCE
327
CASE STUDIES AND CROSS-COUNTRY REVIEWS
328
THE EVOLVING INSTITUTIONAL AGENDA FOR SOUND FINANCE
Table 1
329
CASE STUDIES AND CROSS-COUNTRY REVIEWS
law countries use public credit registries more frequently to facilitate the flow
of information about reputation. Three-quarters of them have public registries,
compared with a quarter of common law countries and Nordic countries.
Legal tradition, however, is not destiny. Institutional structures and prac-
tices can adapt to legal tradition, and many countries have undertaken reforms
to address specific deficiencies. What matters are legal outcomes that have a
bearing on efficient financial sector development. Table 2 provides indicators
of the time and costs of contract enforcement and for closing a business which
vary significantly despite legal traditions and legal creditor rights.3 This shows
that legal efficiency can be achieved under different legal traditions. A lot of
change is taking place due to legal reforms that improve legal efficiency—
judicial processes are being simplified through reforms. A key element of suc-
cessful reform in the area of legal framework is to design flexible mechanisms
that allow different choices for the adoption and implementation of princi-
ples and regulations and that allow lawmakers to adopt approaches to best
accommodate their needs. As countries go up the income ladder they tend to
acquire better and more efficient legal institutions. Country wealth has high
correlation with the quality of legal institutions—richer countries have more
developed judicial systems (more resources to establish specialized courts,
train judges and support staff and bring the latest technology to the court-
room).
330
Table 2
Efficiency of the legal system—creditor rights, ease of contract enforcement and business closure
Creditor rights Enforcing contracts Closing a business
Legal rights Number of Time Cost Time Cost Recovery rate
Country index procedures (days) (% of debt) (years) (% of estate) (cents on the dollar)
Argentina 3 33 520 15 2.8 18 23.5
Australia 9 11 157 14.4 1 8 80.0
Brazil 2 25 566 15.5 10 8 0.2
Canada 7 17 346 12 0.8 4 89.1
China 2 25 241 25.5 2.4 18 35.2
France 3 21 75 11.7 1.9 8 46.6
Germany 8 26 184 10.5 1.2 8 50.3
India 4 40 425 43.1 10 8 12.5
Indonesia 5 34 570 126.5 6 18 10.6
Italy 3 18 1,390 17.6 1.2 18 43.5
331
Japan 6 16 60 8.6 0.5 4 92.4
Mexico 2 37 421 20 1.8 18 64.5
Saudi Arabia — 44 360 20 2.8 18 31.7
South Africa 6 26 277 11.5 2 18 31.8
Turkey 1 22 330 12.5 2.9 8 25.7
United Kingdom 10 14 288 15.7 1 6 85.8
United States 7 17 250 7.5 3 8 68.2
G20 average 5 25 380 22.8 3 12 46.6
Sample average 5 30 381 30.1 3.3 16 32.6
Best practice 11 27 4.2 0.4 1 92.4
Australia Tunisia Norway Ireland Colombia, Finland, Japan
Kuwait, Netherlands,
THE EVOLVING INSTITUTIONAL AGENDA FOR SOUND FINANCE
Norway, Singapore
— Not available.
Source: World Bank, Doing Business Database, 2005
CASE STUDIES AND CROSS-COUNTRY REVIEWS
sale and collection of intangible assets, such as debt owed to third parties. And
the legal framework for secured lending should provide for creation, recog-
nition and enforcement of security interests in all types of assets.
The threat of and recourse to bankruptcy is an important pillar of an
overall effective system of creditor rights. The goals of bankruptcy are uni-
versal: to maximize the value of total proceeds received by creditors, share-
holders, employees and other stakeholders (hence to rehabilitate viable
businesses and liquidate unviable ones) and to ensure priority of claims and
smooth transition in the bankruptcy process.
The legal framework for corporate insolvency should establish a collec-
tive process for resolving or adjusting the rights and interests of a variety of
stakeholders in a failed business. Each country’s system balances several poli-
cies and objectives as determined by its policymakers. Invariably a system
includes a number of potentially diverging policies and interests that must be
balanced and harmonized to make it functional and meaningful within the
context of a particular country’s needs. These include governmental and polit-
ical objectives, cultural and social concerns, and economic and commercial
interests. A well functioning system of commercial insolvency rests on legal,
institutional and regulatory pillars that together create a collective process for
resolving and adjusting interests of stakeholders in a failed business. Each of
these pillars is equally important to creating an effective and efficient system
for users. The absence or inefficiency of any one of these pillars compromises
the entire system.
Though approaches vary, there are a number of common objectives and
goals that apply to commercial insolvency systems. They should aim to:
• Provide for timely, efficient and impartial resolution of insolvencies.
• Be well integrated with a country’s broader legal and commercial sys-
tems.
• Maximize the value of a firm’s assets and recoveries by creditors.
• Provide both efficient liquidation of nonviable businesses and those
where liquidation is likely to produce a greater return to creditors
and rehabilitation of viable businesses.
• Strike a careful balance between liquidation and reorganization,
allowing for easy conversion of proceedings from one procedure to
another.
• Provide for equitable treatment of similarly situated creditors, includ-
ing similarly situated foreign and domestic creditors.
• Prevent the improper use of the insolvency system.
332
THE EVOLVING INSTITUTIONAL AGENDA FOR SOUND FINANCE
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
334
THE EVOLVING INSTITUTIONAL AGENDA FOR SOUND FINANCE
As part of the ROSC initiative, the World Bank has developed a program
to assist member countries in strengthening their financial reporting regime
through the implementation of IFRSs and International Standards on
Auditing. The program’s objectives are to assess accounting and auditing prac-
tices and to develop a country action plan to address identified gaps. Its assess-
ment activities cover the following:
• Comparability of national accounting and auditing standards with
IFRSs and International Standards on Auditing respectively.
• Extent of compliance with established accounting and auditing standards,
rules and regulations, and effectiveness of enforcement mechanisms.
• Strengths and weakness of the institutional framework in supporting
high-quality financial reporting.
The ROSC initiative seeks to focus on compliance with national stan-
dards and on fostering a country-led program to strengthen the standards
toward compliance with IFRs. The focus on adherence to national standards
is based on the recognition that countries must be given time to develop a suf-
ficient infrastructure to effectively adopt international standards. Untimely
adoption may be more detrimental than beneficial. Therefore, the emphasis
is on ensuring that financial statements, which are used across borders, accord
with national standards, while promoting adoption of IFRs over time.
The following are among the key issues and lessons that have emerged to
date from the ROSC initiative:
• Adopting IFRs and International Standards on Auditing as applicable
standards is crucial in all countries, particularly when business enti-
ties contribute materially to the economy or public interest. However,
if there is a lack of efficient and effective monitoring and enforcement
mechanisms, which creates an environment of noncompliance, adopt-
ing the standards is not sufficient. This is often the case in developing
countries and emerging markets. Market forces provide positive incen-
tives to comply with high standards, but experience with both devel-
oped and developing economies suggest that countervailing
disincentives operate to discourage such compliance. A full and bal-
anced combination of strengthening capacity and incentives both pos-
itive and deterrent are needed for successful implementation of
international standards. Similarly, wholesale adoption of the standards
without simultaneously developing the necessary legal and institu-
tional infrastructure and improving professional skills in auditing and
accounting may be an inappropriate solution.
335
CASE STUDIES AND CROSS-COUNTRY REVIEWS
336
THE EVOLVING INSTITUTIONAL AGENDA FOR SOUND FINANCE
C ORPORATE GOVERNANCE
The experience with financial crises and with economic transition has under-
lined the importance of good corporate governance for financial sector devel-
opment and for financial stability. Corporate governance constitutes the set
of relationships between a company’s management, its board, its sharehold-
ers and other stakeholders. These relationships define, among other things, the
property rights of shareholders and the mechanisms of exercising and pro-
tecting these rights to ensure a fair return. Corporate governance also provides
the structure through which the objectives of a company or financial institu-
tion are set and the means for attaining and monitoring those objectives. Good
corporate governance should provide proper incentives and means for the
board and management to pursue objectives that are in the interests of the
company and its shareholders.
There is strong empirical evidence to suggest that good corporate gover-
nance contributes to efficient financial markets by increasing the efficiency of
capital allocation within and across firms, reducing the cost of capital for
issuers, broadening access to capital, reducing vulnerability to crises, fostering
savings and rendering corruption more difficult. A corporate governance
framework encompasses three primary areas: laws, regulations and decrees that
provide the legal framework for the commercial sector; regulatory agencies
responsible for the enforcement of legislation; and common market practices
(or business culture) that can be as important as legislation and institutions.
In response to a call by the Organisation for Economic Co-operation and
Development (OECD) Council Meeting at the ministerial level, the OECD
developed and issued in 1999 the OECD Principles of Corporate Governance
following extensive consultations. They represent the minimum standard that
countries with different traditions could agree on, without being unduly pre-
scriptive. The Principles were designed with four fundamental concepts in
mind: responsibility, accountability, fairness and transparency. The principles
were reviewed and revised in April 2004 based on a comprehensive survey of
corporate governance practices, including a review of practices outside the
OECD area derived from regional corporate governance roundtables orga-
nized by the OECD in partnership with the Bank. Topics that received par-
ticular attention in the revision included strengthened principles to reinforce
board oversight and independent judgment and new and strengthened prin-
ciples to contain conflicts of interest through enhanced disclosure and trans-
parency, making auditors more accountable to shareholders and promoting
auditor independence.
337
CASE STUDIES AND CROSS-COUNTRY REVIEWS
338
THE EVOLVING INSTITUTIONAL AGENDA FOR SOUND FINANCE
339
CASE STUDIES AND CROSS-COUNTRY REVIEWS
preparation for privatization, drafting laws and regulations, carrying out stud-
ies, diagnosing or auditing financial institutions, and in general, providing
technical support to the reforms supported through adjustment lending. The
remaining technical assistance includes support for capacity building in pen-
sions and insurance systems, micro, small and medium-size enterprise finance,
housing finance and payment systems. IFC’s institution and capacity build-
ing activities, which exceeded $41 million for 83 projects in fiscal 2004, help
financial institutions develop core operations, such as credit, asset-liability
management, internal risk management and corporate governance. IFC is also
involved in capacity building through its financial sector investments, which
compose 35–40 percent of new operations.
About 380 professionals in the World Bank Group cover a wide range of
financial sector expertise, assisting institutional reforms and capacity build-
ing to strengthen regulatory frameworks and market infrastructures. Over fis-
cal 2000–04 Bank staff delivered $73.4 million equivalent of nonlending
technical assistance services supported by the Bank’s budget and trust funds.
These services included support for follow up of the FSAP recommendations
in banking, regulatory reforms, corporate insolvency, financial disclosure and
access to finance for small and medium-size enterprises. In addition to the
Bank’s operational units, its treasury has brought to bear its considerable
financial market and asset management expertise to assist member central
banks in building expertise in the management of their foreign exchange
reserves. IFC similarly provides technical assistance activities related to invest-
ments in the financial sector as well as training in corporate governance.
The World Bank Group has an extensive training and learning program to
complement its lending and technical assistance activities. The training and
learning program is aimed at financial sector policymakers, regulators, practi-
tioners as well as members of civil society in developing countries. It pursues
capacity building through global conferences and seminars, regional work-
shops and country-level seminars, which customize content for specific client
countries. Capacity building activities are also delivered via distance learning,
electronic learning tools, as well as targeted curriculum development for finan-
cial sector learning. The program covers a wide range of topics such as bank-
ing and banking supervision, bank insolvency, financial sector policy,
anti–money laundering and countering the financing of terrorism, capital mar-
ket development, pensions and insurance, housing finance, risk management
and access to finance. The number of learning events under the program has
grown sharply over the past three years, from 12 in fiscal 2002 to 43 in fiscal
340
THE EVOLVING INSTITUTIONAL AGENDA FOR SOUND FINANCE
2004. The 43 learning events in fiscal 2004 comprised 10,600 training days and
reached more than 3,700 participants from more than 60 countries.
The FSAP and related ROSCs are leading to a better identification of and
growing demands for technical assistance and capacity building. The FSAP is
a comprehensive diagnostic tool that helps identify gaps and issues that need
to be addressed to develop a more diversified, competitive and inclusive finan-
cial sector. Based on its findings, assessed countries formulate sector strategies
and reform programs, often assisted by technical assistance and other follow-
up work by the two institutions or other donors. In some countries an updated
anti–money laundering and countering the financing of terrorism legal and
regulatory framework is also needed, and significant gaps remain.
Implementation remains a challenge for many countries, often due to
insufficient resources and training. As a result, substantial World Bank Group
resources are increasingly devoted to FSAP follow-up (about 45 percent of
total lending in the financial sector for fiscal 2003–05). Europe and Central
Asia and Latin America and the Caribbean are the Bank’s regions that use
most of the lending programs to take advantage of the analytical underpin-
nings provided by the FSAPs.
Follow-up technical assistance is also provided by other donors and institu-
tions cooperating with the Bank and the IMF. The Bank and the IMF work closely
with the regional multilateral development banks to coordinate the provision of
technical assistance in order to leverage financial resources and reduce overlaps.
The Financial Sector Reform and Strengthening initiative—a $53 million
multidonor facility—was established by the Bank and the IMF, along with the
United Kingdom and other donors, to facilitate the systematic follow-up of the
recommendations from the FSAP and ROSCs. In addition, the initiative helps
eligible countries strengthen their financial systems and implement interna-
tionally recognized standards and codes, in advance of participation in the
FSAP and the ROSC initiative. It also provides technical assistance grants to
recipients in developing and transition countries for capacity building and
policy development in financial sector regulation, supervision and develop-
ment. As of end-June 2005 the initiative had approved 168 projects for a total
commitment of $28.7 million, and 39 of them were fully completed. Sub-
Saharan Africa had the most projects, followed by Latin America and Europe
and Central Asia.
The policy recommendations set forth in the accounting and auditing
ROSC assessments have increasingly served as a platform for encouraging
demand-driven accounting and auditing reform in client countries. A critical
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CASE STUDIES AND CROSS-COUNTRY REVIEWS
342
THE EVOLVING INSTITUTIONAL AGENDA FOR SOUND FINANCE
Corporate governance activities at the firm level, which take place under
the aegis of the IFC, include a strong emphasis on sound corporate gover-
nance regimes and inclusion of corporate governance analysis in all phases of
IFC investment work, as well as training programs for company directors and
senior management of private firms. A Web-based methodology has also been
developed to provide continuously updated procedures and tools for corpo-
rate governance evaluations.
The pilot assessments on insolvency and creditor regimes have led to
demands for follow-up support in several instances. In some cases the assess-
ments fed into action plans in connection with Bank policy-based operations;
in these and other cases the assessments also informed or contributed to tech-
nical assistance programs designed to promote legal and regulatory reforms
and capacity building. In several countries ROSC assessments on the insol-
vency and creditor regimes also benchmarked and provided comments on
pending or proposed insolvency legislation, in addition to assessments of the
existing legal framework. The Bank has been collaborating with a range of
partners on policy dialogue and capacity building related to insolvency reform
including OECD, the regional development banks, the Asia-Pacific Economic
Cooperation, the European Commission and various nongovernmental orga-
nizations, including the International Association of Restructuring, Insolvency
and Bankruptcy Professionals, the International Association of Insolvency
Regulators, the International Bar Association, the Inter-Pacific Bar Association
and the American Bankruptcy Institute.
N OTES
1. See World Bank (2001a) for a review of research findings on finance and
growth.
2. See, for example, La Porta and others (2000).
3. The methodology used to define the benchmarks and the indicators used
are described in detail in World Bank (2005).
4. The principles are under revision based on further feedback, consultations
and lessons learned from the pilot ROSCs. The Bank is currently collaborating
with the IMF and the United Nations Commission on International Trade Law
to develop a unified standard on insolvency and creditor rights systems.
5. Trends in globalization, capital flows, regionalization and technology are
influencing the standards-setting process. Recent events in industrial countries
relating to corporate business failings and inaccuracies in financial reporting have
also brought attention to the role and oversight of the accounting and auditing
profession, the governance of standards-setting bodies, and the scope of corporate
343
CASE STUDIES AND CROSS-COUNTRY REVIEWS
R EFERENCES
Basel Committee on Banking Supervision, 1999. Enhancing Corporate Governance
for Banking Organizations. Bank for International Settlements, Basel.
Beck, T., A. Demirgüç-Kunt, and R. Levine. 2003. “Law, Endowments, and
Finance.” Journal of Financial Economics 70(2): 137–81.
Diamond, J. 1997. Guns, Germs, and Steel: The Fates of Human Societies. New
York: W.W. Norton.
Easterly, W., and R. Levine. 2003. “Tropics, Germs, and Crops.” Journal of
Monetary Economics 50(1): 3–39.
La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny. 1997. “Legal
Determinants of External Finance.” Journal of Finance 52(3): 1131–50.
———. 1998. “Law and Finance.” Journal of Political Economy 106(6): 1113–55.
———. 2000. “Investor Protection and Corporate Governance.” Journal of
Financial Economics 58(1–2): 3–27.
OECD (Organisation for Economic Co-operation and Development). 2004.
Principles of Corporate Governance. Paris.
Rodrik, D., A. Subramanian, and F. Trebbi. 2004. “Institutions Rule: The Primacy
of Institutions over Geography and Integration in Economic Development.”
Journal of Economic Growth 9(2): 131–65.
World Bank. 2001a. Finance for Growth: Policy Choices in a Volatile World. Policy
Research Report. Washington, D.C.
———. 2001b. Principles and Guidelines for Effective Insolvency and Creditor Rights
Systems. Washington, D.C.
———. 2004. Doing Business in 2004: Understanding Regulation. Washington,
D.C.
———. 2005. Doing Business in 2005: Removing Obstacles to Growth. Washington,
D.C.
344
PART III
G20 WORKSHOP
ON D EVELOPING
S TRONG D OMESTIC
F INANCIAL M ARKETS
O TTAWA , C ANADA
26–27 A PRIL 2004
S UMMARY OF P ROCEEDINGS
FROM THE G20 WORKSHOP
ON D EVELOPING S TRONG
D OMESTIC F INANCIAL M ARKETS
P REPARED BY THE B ANK OF C ANADA AND THE D EUTSCHE B UNDESBANK
O TTAWA , C ANADA , 26–27 A PRIL 2004
In April 2004 the Deutsche Bundesbank and the Bank of Canada co-hosted a
G20 workshop in Ottawa titled “Developing Strong Domestic Financial
Markets”. The workshop broadened and deepened earlier work on building insti-
tutions in the financial sector that will foster economic development and growth.
At the Ottawa workshop G20 representatives, prominent academics, market par-
ticipants and members of international financial institutions shared experiences,
explored how robust domestic financial markets can promote economic growth
and development and, where possible, developed policy recommendations.
G ENERAL SUMMARY
Participants agreed that strong domestic financial markets are a key factor in
economic growth and development—and that appropriate policies, institutions
and incentives are at the heart of market development. There was also a con-
sensus that strong local banking systems and securities markets reduce a coun-
try’s external vulnerability. They enhanced the collection and allocation of
domestic savings. And they attract foreign investment in instruments denom-
inated in the domestic currency as an alternative source of external funding.
It was agreed that currency mismatches (foreign currency liabilities and
domestic currency assets) were a common element in recent financial crises in
emerging market economies. It was also agreed that such mismatches should
be assessed by examining the discounted present value of a country’s future
income and expenditure flows under alternative exchange rate assumptions.
Participants broadly supported the sequence of market reforms. First,
establish sound macroeconomic policies. Then, liberalize domestic financial
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WORKSHOP ON DEVELOPING STRONG DOMESTIC FINANCIAL MARKETS
dollar, the high correlation between Asian and U.S. yields would diminish,
increasing the attractiveness of Asian securities for those seeking to diversify
their portfolios.
350
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General discussion
Participants debated whether currency mismatches can be significantly reduced
by appropriate economic policies and institution building in emerging market
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WORKSHOP ON DEVELOPING STRONG DOMESTIC FINANCIAL MARKETS
352
OTTAWA
(venture capitalists and stock markets, notably in the United States). In con-
trast, the second industrial revolution, geared to exploiting scale economies
(mass production), was fueled by internal finance. So, the financial structure
had to take into account the characteristics of the main drivers of economic
growth.
Second, information and contractual arrangements affect the efficiency
of the financial system. Asymmetric information leads to agency problems,
favoring debt finance and monitoring of borrowers by financial intermedi-
aries. When information is more widely available, capital markets function
more efficiently. Incentives, rewards and controls (through regulation) con-
dition risk-taking, as well as inclinations for misreporting, and even fraud.
Third, while such financial innovations as securitization and derivatives
have allowed a greater diversification of risk, the shift of risks to contractual
savings managed by pension funds and insurance companies needs to be
examined. If they are bearing too much risk now, moving from public to pri-
vate sector pension schemes will be less attractive.
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WORKSHOP ON DEVELOPING STRONG DOMESTIC FINANCIAL MARKETS
General discussion
Several points were raised in the general discussion. Since the financial
resources of emerging market economies are limited, increasing domestic sav-
ings ratios is important in poorer countries, and greater official development
assistance would be welcomed. For many developing countries, there is also
the challenge of identifying viable projects that might interest domestic or
foreign investors. For institution building, it is important to get things right
the first time. The development of domestic markets was also viewed as most
relevant for countries with high savings rates, such as those in East Asia.
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WORKSHOP ON DEVELOPING STRONG DOMESTIC FINANCIAL MARKETS
General discussion
There was broad agreement with McKinnon’s proposed sequence of reforms,
especially the proposition that sound macroeconomic policies are a prereq-
uisite for successful financial liberalization. There was less agreement, however,
on his recommendation of a system of fixed exchange rates based on the U.S.
dollar. Some participants questioned the claim that creditor emerging market
economies subject to conflicted virtue would face continuous pressure to
appreciate their currencies, resulting in deflation. While extrapolative expec-
tations might pose a potential risk if the proposed revaluation failed to elim-
inate the gap between the actual exchange rate and the perceived equilibrium
rate, it was not clear why there would be expectations of further appreciation
once the perceived equilibrium rate was reached.
For China, there was a broad consensus that bank balance sheets would
have to be strengthened before the authorities proceeded with further capital
account liberalization. Yet some participants expressed concerns that too lit-
tle attention had been paid to exchange rate issues: a more flexible exchange
rate regime would reduce the risks associated with capital account liberaliza-
tion in China. It was also noted that it is difficult to foster the use of hedging
instruments under fixed exchange rates.
The representative of the People’s Bank of China responded by noting that
the goal of the Chinese authorities is to liberalize long-term capital flows before
short-term flows. Moreover, the exchange rate should reflect overall competi-
tiveness, not just the competitiveness within the traded goods sector. He opined
that the current exchange rate is broadly appropriate. McKinnon also observed
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WORKSHOP ON DEVELOPING STRONG DOMESTIC FINANCIAL MARKETS
corporate governance is a process (IIF 2002, 2003). Investors are aware that it
takes time to implement good corporate governance practices. What is impor-
tant is that there be ongoing progress.
Finally, Miltner turned her attention to corporate governance in major
emerging market economies, noting that they share some common features.
First, ownership and control structures are often opaque, contributing to a lack
of accountability. As examples, she cited the oligarchs in Russia, the chaebols
in the Republic of Korea and family conglomerates in Indonesia. China also
poses challenges, given its mix of private and state-controlled firms. Second,
boards of directors frequently lack independence. Third, disclosure is often
inadequate. Finally, enforcement is often weak, reflecting a lack of suitably
trained judges and well equipped regulators.
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General discussion
Participants generally concentrated on issues related to corporate boards and
disclosure. Many participants commented on the importance of a corporate
culture that supports appropriate risk management. Concern was also
expressed about the ability of firms to find competent, independent board
members. One participant observed that this is a problem even in major
industrialized countries. Bhattacharya concurred, noting that, in many emerg-
ing market economies a shortage of qualified people in an environment of
interconnected businesses makes it very difficult to find qualified individuals
who are truly independent.
There was also considerable discussion on the appropriate degree of trans-
parency. While participants broadly agreed that greater disclosure is important,
some wondered whether there could be too much disclosure. In some indus-
trialized countries, rising disclosure requirements have been an incentive for
publicly held companies to go private. Miltner responded that greater disclosure
is something investors wanted. While a case for too much disclosure could be
made in theory, the issue was irrelevant in emerging market economies.
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WORKSHOP ON DEVELOPING STRONG DOMESTIC FINANCIAL MARKETS
360
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General discussion
Participants agreed that foreign investors could improve the liquidity and
competitiveness of local financial markets. Concern was expressed, however,
that they might increase the volatility of asset prices. Many participants also
noted that, while there has been considerable success in developing local mar-
kets for public debt instruments, progress had been more limited for corpo-
rate bonds. Other issues explored included whether countries should favor
local or regional market strategies, how to regulate different institutions, how
to avoid distortionary incentives for risk-taking, the extent to which securiti-
zation should be encouraged and the extent to which capital markets (which
might draw off higher quality borrowers) would increase the riskiness of bank
loan portfolios.
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WORKSHOP ON DEVELOPING STRONG DOMESTIC FINANCIAL MARKETS
C ONCLUDING OBSERVATIONS
Presenter: Morris Goldstein, Institute for International Economics
Noting the diverse membership of the G20 and the utility of the forum for
sharing experiences, Morris Goldstein identified seven key policy themes.
1. Domestic financial markets are increasing in importance in many emerg-
ing market economies, in both size and function. He noted two caveats
in particular that countries would do well to heed. First, while it is bet-
ter to have a larger share of debt owed to domestic creditors for a given
ratio of debt to GDP, the level of debt is also important. In this respect,
he cited recent IMF work indicating that defaults in emerging market
economies have occurred at relatively modest levels of debt to GDP. The
second caveat was that governments need to continue to improve bank
soundness, especially given the potential fiscal liabilities of bank failures.
2. Diversification. If the golden rule of real estate is “location, location,
location”, Goldstein argued, then the key message from the work-
shop was “diversification, diversification, diversification”. He noted
that the development of multiple sources of finance (such as banks
and securities markets) would help in the event of a loss of access to
any particular source.
3. Policy incentives are at the heart of building capital markets. The chal-
lenge is to create the right incentives for both private participants and
the authorities to foster market development and prudential supervision.
4. Appropriate sequencing of liberalization. Goldstein noted that there was
broad support for McKinnon’s ordering: fiscal balance followed by
domestic financial sector reforms and opening the current account before
liberalizing capital flows (beginning with foreign direct investment).
5. Implementing and enforcing standards and codes, such as those relat-
ing to transparency and corporate governance. Goldstein noted that
the most powerful incentive for complying with standards and codes
would be in the lower market borrowing costs that resulted from
compliance. More evidence on this link would be most useful.
6. Market liquidity matters. Governments could promote market liq-
uidity through greater transparency in the scheduling of borrowing
programs, the promotion of effective settlement and clearing systems
and the introduction of new financial instruments to help complete
financial markets. Macroeconomic policy frameworks were consid-
ered equally important, since high and volatile inflation deters the
development of local bond markets.
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N OTES
1. Turner drew from a recent book he wrote with Morris Goldstein, Control-
ling Currency Mismatches in Emerging Markets (2004).
2. Creditor countries are virtuous because they are large savers, but have con-
flicted feelings about their virtue because the implications of their virtue—con-
tinuous upward pressure on their exchange rate—are undesired.
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Eichengreen, B., and R. Hausmann. 1999. Exchange Rate and Financial Fragility.
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Intolerance and Original Sin: Why They Are Not the Same and Why It Matters.
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and Transparency in Emerging Markets.” Equity Advisory Group, Washing-
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———. 2003. “Policies for Corporate Governance in Emerging Markets: Revised
Guidelines.” Equity Advisory Group, Washington, D.C.
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McKinnon, R. 1993. The Order of Economic Liberalization: Financial Control in the
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Turner, P., and M. Goldstein. 2004. Controlling Currency Mismatches in Emerging
Markets. Washington, D.C.: Institute for International Economics.
363