Chapter

IV. Surveillance over Global Financial Markets: Broadening Current Arrangements

Author(s):
International Monetary Fund
Published Date:
September 1996
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The efforts of the Group of Ten countries in formulating and implementing a supervisory and regulatory response to the challenges posed by the evolving international financial environment are by and large viewed as having been successful. There were a number of near misses, but these have to be seen in light of the magnitude of the changes that have taken place in the international financial system. However, supervisors and market participants are keenly aware of the challenges that still lie ahead. In particular, it is widely recognized that the strengthening of the regulatory environment and of prudential oversight over the international banking system will need to be extended to include the growing number of systemically important emerging market countries. The need to strengthen supervisory and regulatory infrastructure outside the Group of Ten countries is, of course, not only driven by systemic concerns about the stability and efficiency of the international financial system, but also by the recognition that a sound financial system can make important contributions to the economic performance of all countries, including those that are not yet significant participants in the international financial system.

During the 1990s, a number of developing countries, particularly in Asia, became important participants in international financial markets. The trend growth of net capital flows to these countries indicates a growing exposure on the part of investors from industrial countries. Likewise, the net external asset position of banks in the major industrial countries with banks in some of the emerging market countries is growing rapidly; for example, during 1990-95 net loans to Thailand expanded from $5 billion to $68 billion, and to Korea from $14 billion to $44 billion (Table 4). The increase in the relative size of the financial sectors of selected emerging market countries vis-à-vis the financial sectors in the Group of Ten countries can also be seen in the growth of the relative size of their equity market capitalization and in the increase in their stock of net international reserves (Chart 12). Furthermore, Singapore and Hong Kong have become the fourth and fifth largest global foreign exchange trading centers (Table 5).

Supervisors, international banks, and institutional investors generally cite two reasons why it is desirable for the international community to extend the improvements in the management of risk and in prudential supervision to the systemically important emerging market countries. First, financial crises in these countries tend to have a crippling impact on their economic performance,20 with potentially adverse consequences for their trade and financial partner countries, as was demonstrated during the 1995 crisis. Capital markets have remained relatively underdeveloped in most emerging market countries, and the banking system typically still plays a central role: it intermediates the overwhelming share of domestic saving, as well as a large part of cross-border capital flows. Its importance in developing economies has meant that the quality of its assets are particularly vulnerable during economic downturns, and it also might bear the brunt of any increase in short-term interest rates that a defense of an exchange rate might entail in the face of a sudden capital outflow.

Second, market participants stress that the further integration of the emerging market countries into the international financial system will, inter alia, require that both the quality of prudential supervision and the ability of financial institutions in these countries to manage risk be raised to international standards. Only then will their industrial country counterparties be prepared to deal with them on similar terms relating to access, spreads, collateral requirements, maturity, and restrictive covenants, as are available to institutions from other industrial countries.

There are a number of features of financial systems in emerging market countries or regions that in some cases have tended to make financial surveillance in these countries more difficult. For example, the technical ability and the availability of resources in the supervisory community tend to be sparser than in the Group of Ten countries (Hong Kong and Singapore are notable exceptions), and may not have kept up with the increasing sophistication of internationally active financial institutions. Legal systems have made it occasionally difficult for supervisors to implement prudential directives, including cease-and-desist orders. In cases where the economy is dominated by a small number of large corporate groups, it is sometimes difficult to avoid concentrations of risk and ownership. In addition, extensive implicit and explicit financial safety nets have tended to remove some of the discipline imposed by the market on the credit allocation process. The development of financial accounting may for various reasons not have kept up with the rapidly expanding activities of internationally active banks. Furthermore, discussions with banks in some of the relevant offshore centers confirmed reports from the major domestic banks that there is a growing propensity of domestic and foreign banks to shift the location of some of their wholesale activities in emerging markets to offshore locations, and to alter their risk positions through the use of derivatives and offshore transactions. Hence, the ability of domestic bank supervisors to gain a consolidated picture of the activities and exposures of their domestic institutions is not always adequate.

Some of the problems and difficulties encountered in the surveillance of banking systems in emerging market countries become more clearly apparent when one considers the significant progress made in the major industrial countries. The current approach to the surveillance of international banking activities by the Group of Ten countries is based on finding multilateral cooperative solutions—frequently involving agreed minimum standards and assignments of supervisory responsibilities between home and host countries. This approach has been driven by the recognition that global financial markets have become a reality and that the surveillance over these markets cannot effectively be accomplished with a nationally focused strategy. Further, it is feared that regulatory arbitrage by financial institutions, as well as competition among financial authorities for a greater share of the international financial services industry, would produce a less than desirable outcome. Since financial institutions can to some degree shift transactions from the purview of their home supervisors, national regulators simply cannot ignore the fact that prudential restrictions, imposed as a quid pro quo for a national financial safety net, can to some extent be evaded.

Table 4.Net External Assets of BIS-Reporting Banks vis-à-vis Banks in Selected Countries and Regions1(in billions of U.S. dollars)
199019911992199319941995
Hong Kong69107221256134219
Singapore44687084102117
Mexico461011166
China-21-20-16-11-16-7
Indonesia22161013
Korea141919203044
Malaysia-4-3-3-5-23
Thailand5914234068
Australia161620191517
New Zealand458546
Source: Bank for International Settlements (BIS).

BIS reporting banks arc banks in the following countries or areas: Austria, Belgium, Canada, Denmark. Finland. France, Germany, Ireland, Italy, Japan, Luxembourg, the Netherlands, Norway, Spain, Sweden, Switzerland, United Kingdom, United Stales, the Bahamas, Bahrain, the Cayman Islands, Hong Kong, the Netherlands Antilles, and Singapore.

Source: Bank for International Settlements (BIS).

BIS reporting banks arc banks in the following countries or areas: Austria, Belgium, Canada, Denmark. Finland. France, Germany, Ireland, Italy, Japan, Luxembourg, the Netherlands, Norway, Spain, Sweden, Switzerland, United Kingdom, United Stales, the Bahamas, Bahrain, the Cayman Islands, Hong Kong, the Netherlands Antilles, and Singapore.

Efforts to reach cooperative agreements on minimum prudential standards for financial markets and on a protocol for the sharing of supervisory responsibility among the relevant supervisory authorities in globally integrated markets have been carried out by the Basle Committee on Banking Supervision.21 The Committee, consisting of representatives of the Group of Ten and with a permanent secretariat at the BIS, was established in the aftermath of the Herestatt crisis in foreign exchange markets in 1974. and it has served as the focal point for issues relating to the supervision of international banks.22

Two other committees have also contributed in addressing systemic issues. The Eurocurrency Standing Committee was created in 1962 in response to concerns about the growth of the Eurodollar markets, and it is largely concerned with the systemic implications of developments in financial markets. A third standing committee, the Committee on Payment and Settlement Systems (CPSS), was set up in 1989 in response to the perception that risk in cross-border wholesale payments systems was growing beyond manageable limits. It has focused its work on agreeing standards for wholesale payments systems.

The Basle Committee identified key issues relating to the safety and soundness of the banking system, and has served as an effective forum for forging international agreements on standards or principles in this area. Its success is to a very large extent due to two factors. First, the Committee does not have any international or cross-border means of enforcement; instead, enforcement is left to the national supervisory authority. No aspect of national sovereignty is compromised. The Committee has also been careful to involve the international banking industry in achieving a consensus. The second main source of the Commit-tee’s strength and success, but one that could also become a weakness in future years, is that its membership has remained small and unchanged despite the restructuring of the global financial system that has taken place since its inception. In this setting, agreements can be reached through a process of mutual education and persuasion. The limited size and the stable membership of the Committee has served to build effective working relationships among the key Group of Ten supervisors, and these relationships have at times been instrumental in resolving potential cross-border Financial problems.23

Chart 12.Growing Influence of the Emerging Markets, Australia, and New Zealand 1

(In percent of totals for Group of Ten countries)

Sources: International Finance Corporation, Emerging Stock Markets Factbook, various issues; and International Monetary Fund, International Financial Statistics and World Economic Outlook databases.

1 The group emerging markets, as defined by the International Finance Corporation, consists of 26 countries. Australia and New Zealand have weights of 8.5 percent, 3.5 percent, and 12.0 percent in the calculations for GDP, total reserves minus gold, and stock market capitalization, respectively.

The Basle Committee on Banking Supervision has been able to reach agreements in two areas that are key to the successful supervision of global markets. The first has been the assignment of supervisory responsibility between home and host countries—a defining issue in the supervision of international markets. The 1975 Basle Concordat developed the principle that the home country is responsible for supervising the global operation of international banks in its jurisdiction on the basis of a consolidated balance sheet. The agreement was strengthened on several occasions, most importantly in the aftermath of the failure of the Bank of Credit and Commerce International (BCCI). The Committee reached agreement in 1992 on a set of minimum standards for the supervision of international banks and their cross-border establishments. The standards set out the right of the home country supervisor to obtain data needed for the consolidated supervision of international banks. The standards also strengthened the authority of the host country to impose restrictive measures if the minimum standards are not met, such as imposing deadlines to meet acceptable standards, obliging foreign branches to be restructured as separately capitalized entities, and even closing banking establishments. The second major set of agreements have been in the area of regulatory capital requirements for international banks discussed in the previous section.

Table 5.Foreign Exchange Market Turnover
198919921995
(In billions of U.S. dollars)
Global estimated turnover15908201,190
(in percent)
Currency composition (at least
one side of a transaction
denominated in)2
U.S. dollar903283
Deutsche mark274037
Japanese yen272324
Pound sterling151410
Other414146
Total3200200200
Geographic composition4
United Kingdom262730
United States161616
Japan151110
Singapore877
Hong Kong766
Switzerland865
Source: Bank for International Settlements (BIS)

Daily average global turnover as reported to the BIS, adjusted for estimated gaps in reporting and for local and cross-border double counting (“net-net” basis).

Currency composition was reported by 21 countries in 1989 and by 26 countries in both 1992 and 1995.

Since each transaction involves two currencies, by definition, the percentages add to 200 percent.

The geographic location for turnover was determined by where the transactions were entered into, not the location where the transaction was ultimately booked or managed.

Source: Bank for International Settlements (BIS)

Daily average global turnover as reported to the BIS, adjusted for estimated gaps in reporting and for local and cross-border double counting (“net-net” basis).

Currency composition was reported by 21 countries in 1989 and by 26 countries in both 1992 and 1995.

Since each transaction involves two currencies, by definition, the percentages add to 200 percent.

The geographic location for turnover was determined by where the transactions were entered into, not the location where the transaction was ultimately booked or managed.

Some agreements reached by the Basle committees, such as the 1988 Accord on risk-weighted capital standards for international banks, are also implemented by some countries that are not members of the Group of Ten, This extension of the risk-weighted capital standards has in large part been driven by market forces, as the cost of external funding and the ratings of banks in these countries are increasingly tied to their capital positions, which are relatively easy to monitor. However, other agreements, such as those relating to the sharing of supervisory responsibility and the sharing of supervisory information, are more difficult to implement beyond the committees’ membership, in part because of the confidential nature of supervisory information. Other less tangible benefits (lowing from the work of the committees are also not easily transferred to a larger number of countries. For example, to the extent that there is formal and informal sharing of confidential supervisory information among committee members it is not generally extended to nonmembers. Furthermore, the educational benefits of the consensus-building approach have had a strong positive impact on the quality of prudential supervision in member countries. This aspect of the committees’ work is rather more important than is evident at first glance. For example, the agreement to allow the internal models approach as an alternative measure to incorporate market risks with the current regulatory capital standards was greatly facilitated by a process of education through analytical work done by the major central banks. Finally, the high profile and success of the work of the Basle committees during the last 20 years has given the committees international prominence and prestige, which in turn has added to the authority of the supervisors in member countries to overcome domestic opposition to the implementation of agreed regulatory measures.

There is a widespread agreement among supervisors and market participants in the major industrial countries that a way will have to be found to extend the improvements in the supervisory and regulatory infrastructure in international financial markets—generally perceived as having reduced the risk of systemic disturbances—to the systemically important emerging market countries. But there is little agreement on how to accomplish this goal. Most supervisors in the Group of Ten countries think it unlikely that the existing institutional arrangements for reaching cooperative agreements among the banking supervisors in the Group of Ten countries, anchored in the Basle Committee, can easily be extended to include an increasing number of emerging market countries. Indeed, it is thought that the very success of the current arrangements may well derive from the relatively small number of homogenous participants. Furthermore, efforts to broaden the surveillance of international markets would have to be careful not to disrupt the existing arrangements that have successfully served a large part of the international financial system. In particular, it was thought that any new arrangements would have to complement, rather than replace, existing arrangements.

Private market participants—international banks and institutional investors—are generally supportive of efforts to broaden the surveillance of international markets to include some of the emerging market countries, but there is some concern that any such efforts not lead to inconsistencies with the existing international framework, nor introduce a new layer of restristctions. Although, there is yet little agreement in the official sector on the particulars of such efforts, there is a consensus among supervisors in the major Group of Ten countries and in some emerging markets that any effort to expand the existing arrangements for the supervision of international banking markets to include some of the systemically important emerging market countries will have to be mindful of the three main lessons from the postwar experience with surveillance over the international financial system.

First, international cooperation in the area of financial surveillance should be based on home country control, rather than on supranational legal arrangements. There have to be sufficient incentives—increased integration into international markets, lower cross-border funding costs, and domestic financial stability—for the domestic banking industry in an emerging market country and for its supervisory authorities to support and implement an international agreement. It is thought that legally binding international treaties, such as some trade agreements, would not only be difficult to negotiate in the supervisory and regulatory area, but they would also fail to be sufficiently flexible in implementation or sufficiently timely in responding to the evolving international financial environment.

Second, officials and market participants agreed that international agreements and arrangements should cover all countries with financial institutions that are significant and active players in the international financial markets. The growing ability of financial institutions to shift some of their activities to offshore locations means that in the absence of comprehensive coverage there is likely to be regulatory arbitrage, as well as competition among countries for a larger share of the global financial services industry. Furthermore, since the number of countries with institutions that participate in the international financial markets is likely to increase in the coming years, it was thought important to have a well-established and flexible mechanism for extending the coverage of such agreements to include additional countries.

Third, officials thought that experience had shown that international agreements should be narrowly focused on (1)minimum standards for the regulation and surveillance of internationally active financial institutions; (2) the assignment of responsibility between home and host countries for the surveillance of the operations of international banking institutions; and (3) the exchange of information among national supervisory authorities. All of these three aspects of the surveillance of international markets parallel the work of the Basle process as it has evolved and have proved to be essential during the last ten years to the effective surveillance over the global financial system. For example, the formulation of minimum standards grew from the need to clarify when a host country can deny a foreign bank access to its markets. The division of regulatory responsibility between home and host country is essential to ensure that no aspect of the international operations of a bank goes unsupervised.

Although there are exceptions in some cases, there is broad agreement among supervisors in the major industrial countries that the key items on a list of minimum prudential standards should, inter alia, include (Da requirement that national supervisors have the ability to supervise financial firms on a globally consolidated basis,24 so that no important domestic or foreign banking activity remains without oversight; (2) regulatory capital standards, including standards for the management of market risk; (3) internationally accepted loan-classification and provisioning rules; (4) limits on large exposures (including intra-group exposures): and (5) sufficient legal authority of supervisors to obtain all relevant financial information through on- and off-site inspection and to close financial institutions or limit their activities when regulatory re-quirements are violated. Most supervisors stress that these are minimum standards, and that the standards adopted by individual countries will inevitably reflect differences in financial structure and in financial vulnerability. The regulation of domestic financial activity and institutions should be responsive to domestic circumstances and should remain in the domain of domestic supervisors. There may be a need, however, for internationally agreed standards to guide the regulation of domestic financial activities. Although the promulgation of minimum standards is generally viewed favorably by supervisors and market participants alike, there is wide-spread recognition that the success of such standards is crucially dependent on how comprehensively and rigorously they are implemented.

In the absence of progress in the direction of broadening the existing multilateral framework for the surveillance of international financial market there could be further pressure for additional regional arrangements among supervisors and central banks. The proposal by Governor Fraser of the Reserve Bank of Australia to set up an “Asian BIS” may be a first step toward such a regionalization. Although the definition of minimum supervisory standards does not seem to be envisaged at this time, the exchange of information and cooperation in times of turbulence is a stated objective.25 This is not to say that regional arrangements are not helpful in many areas, but in the area of surveillance of international markets a regional approach alone will not suffice in the longer run. Financial institutions increasingly operate globally in wholesale markets, not simply regionally. This is also the reason why the European Union has tailored much of its legally binding prudential requirements for European Union banks after those of the Basle Committee on Banking Supervision. Nevertheless, regional initiatives, such as the European Union and the Asian initiative, could complement a more global approach by providing a channel for promulgating best practices and implementation and for sharing views and information in both directions.26

20See Lindgren, Garcia, and Saal (1996).
21The International Organization of Securities Commissions (IOSCO), whose members include almost all countries with stock exchanges, is the main multilateral vehicle for cooperation among securities regulators. Its working groups produce recommendations that are advisory and nonbinding on its membership. As a result, there is considerable disparity among its members with regard to implementation. See Annex IV.
22European countries that are not members of the Group of Ten are covered by the supervisory and regulatory arrangement in effect in the European Union, which tend to follow those of the Basle committees.
23The Barings and Daiwa Bank incidents suggest, however, that there is still room for improvement in the coordination and communications among the banking supervisors in the Group of Ten countries and futures markets supervisors. Better communication among the Bank of England, the Singapore International Monetary Exchange (SIMEX), and the Osaka Securities Exchange might have alerted the authorities earlier of the large positions being built up by Barings on the two futures exchanges. The fact that the problem occurred in the overseas securities subsidiary of a bank made the Finance and the U.S. regulators, after the problems at the bank had come to the attention of the ministry in August 1995, were far from perfect. The ministry reaffirmed publicly in December that the exchange of information would have been enhanced had the Basle Concordat been followed. The Barings incident led futures markets regulators to adopt a new set of principles guiding the exchange of information (the so-called Windsor Declaration).
24The meaning of the term “globally consolidated basis” is open to a wide range of interpretations.
25There has also been an effort among some Asian central banks to prepare for sudden pressures on the exchange rate. Several bilateral repurchase agreements to lend and borrow on short notice were concluded among central banks in East Asia in 1995, In April 1996, Japan also signed bilateral accords on repurchase agreements with Australia, Hong Kong, Indonesia, Malaysia, the Philippines, Singapore, and Thailand.
26There are a number of cooperative regional arrangements in Europe, Asia, the Middle East, the developing Western Hemisphere, and in Africa (see Annex IV). These associations tend to be consultative bodies only. In most cases, these regional associations are concerned with providing regional technical assistance and training, combined with some cooperation in banking supervision and regulation, frequently involving the implementation of agreements of the Basle committees.

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