BIS cautions against "big-bang" liberalization

by Chakravarthi Raghavan

GENEVA: "To liberalize financial markets, and especially the capital account in the balance of payments, is not sensible if the supervisory and regulatory framework is inadequate or weak," an official of the Bank for International Settlements (BIS) has said.

In providing this cautionary advice, Mr Elmar Koch has also cautioned against a "big-bang" approach to reforms of the banking sector.

Koch's views on the issue of financial-market liberalization and banking-sector reform were presented at a recent seminar of the UN Economic Commission for Europe, and have been published in the Economic Survey of Europe (1998:2).

While specifically directed to the problems of the transition economies (the former socialist countries of East Europe and the former Soviet Union), much of it seems to be relevant to the developing countries of Asia, Africa and Latin America, all of whom are under pressure from the WTO, the IMF and the US to liberalize.

"Banking-sector reform cannot be seen in isolation from the broader question of financial-sector reform," says Koch. "The financial sector is based on three pillars: the payments and settlement system, financial institutions and financial markets. Developments in the banking sector and any reform of the existing structure should thus ensure that these three pillars remain sound."

The OECD has been stressing that the creation of "transparent, flexible financial systems open to worldwide capital flows is essential if under-developed countries are to achieve strong economic growth in the years ahead," the BIS official notes.

At the same time, the European Bank for Reconstruction and Development (EBRD) has referred to the weaknesses in the banking systems in transition countries, and has said the establishment of sound banking principles and appropriate bank supervision has far to go.

Most central banks are charged with some responsibility in the area of financial-system stability. From an international perspective, the BIS shares the concerns of central banks, said Koch.

Finance and economic growth

When assessing banking restructuring and the inter- dependencies of various economic reforms, both macro-and micro- environments have to be taken into account. One aspect of this complexity is captured by the literature on the "sequencing of reforms". And one should not underestimate the complexity of the problems involved.

The integration of the financial block in economic modelling, on theoretical as well as empirical grounds, remains largely elusive. There is, for example, comparatively little work on the inclusion of the banking system's intermediation function in growth frameworks.

The importance of a "sound" banking system, meaning a system where systemic collapse is unlikely, has come under scrutiny of late, and the situation was exacerbated by the Mexican and, more recently, the Asian crisis. There appears to be much more agreement on the broad principles than ever before.

It is the risk of contagion which is a major reason for official involvement, in one form or another, in the regulation and protection of the financial industry. While individual banks should still be able to go bankrupt, a delicate balance has to be found between eliminating unsound banks and ensuring the continued soundness of the rest of the financial system, and this is the most challenging task.

While it is well documented that remedying financial instability is costly, "there is less evidence of a positive relationship between finance and growth", says Koch.

Most economists acknowledge the interaction between a solid financial system and the growth path. A developed financial sector can raise the productivity of capital by improving the allocation.

But elucidation of the empirical link between financial intermediation and economic growth has invariably been plagued by three major issues: the complexity of the existing financial system; the continuous changes taking place in the financial system as the borders between markets and agents become blurred and overlap; and changing "concepts" of growth. While central bankers are essentially concerned about price stability, a second major goal of theirs is financial stability.

Discussing economic-growth issues in relation to the macroeconomic framework and the need for governments to be wary of allowing exchange-rate misalignments to persist for too long, Koch notes that the significant real effective appreciation till the first quarter of 1997 was among the factors in the recent Asian financial crisis.

No ideal way

"Several East European countries may now face a similar dilemma. In Russia, the real effective exchange rate has risen by a factor of two during the last three years."

In the final analysis, there is no ideal way of conducting reform of the banking sector. While some "big-bang" reforms have been successful, as in the UK in the late 1980s, in many countries, serious thought was given to financial restructuring only under duress.

And since banking crises in individual countries tend to be resolved at a high cost, there seems to be general agreement that preventive action is essential. This cautious approach would place a premium on the stability and safety of the evolving financial system.

"One widely-accepted conclusion," Koch said, "is that to liberalize financial markets, and especially the Capital Account in the balance of payments, is not sensible if the supervisory and regulatory framework is inadequate or weak."

Koch drew attention in this connection to the Basle Core Principles for sound banking supervision, and the recommendations of the Group of 10 on financial stability in emerging markets.

In terms of the situation in the transition economies, three current barriers on the path to successful bank restructuring are: government involvement which throttles financial developments in the private sector; low monetization which prevents serious intermediation by banks; and the fact that most banks in the region remain weak and need strengthening. On this last, Koch underlined the need for strengthening by all countries of financial supervision and implementation along the lines of the Basle Core Principles for banking supervision and for addressing immediately gaps in financial reporting.

In June, at an UNCTAD meeting on portfolio investments, Charles Freeland of the Basle Committee on Banking Supervision, while commending the implementation by everyone of the Basle Core Principles, said that implementation needs a legal culture, a credit culture among banks extending credit, and a prudential regulatory culture among supervisors and regulators of banks, security and insurance firms.

Putting in prudential regulations and implementing them, and establishing the technical expertise and knowledge needed for it, is a long process and cannot be achieved through a 15-day seminar at Basle, he commented. (Third World Economics No. 189, 16-31 July 1998)

Chakravarthi Raghavan is the Chief Editor of the South-North Development Monitor (SUNS).