by Chakravarthi Raghavan

Geneva, 7 Feb 2000 -- It is premature, at best, to establish a global super-regulator to promote crisis prevention worldwide (on the financial markets), and the only feasible solution would be an incremental approach, a staff working paper of the Bank of International Settlements contends. The paper, "What Have We Learned From Recent Financial Crises and Policy Responses," by William R. White, head of the Economic Department of the BIS, is one in a series of BIS staff working papers.

Besides giving technical reasons against the creation of a global super-regulator, the White paper underscores an important point that economists often tend to forget or ignore.

Says White:"A super-regulator with effective powers to set standards and enforce them globally would be enormously powerful. One could argue that national legislators are not yet ready for this."

"Nor do national legislators seem ready to cede the degree of sovereignty that would be needed to make such a super-regulator effective in practice," adds White citing as an example of such resistance to the current US antipathy to the International Monetary Fund and difficulties of obtaining legislation to raise Fund quotas.

On a more technical level of financial expertise, White points out that "..the current knowledge about both the causes and consequences of financial crises is inadequate to support anything but piecemeal solutions," the paper argues.

The BIS staff paper is probably remarkable in what other expert observers see as a case of an institution trying not to expand its own turf, as would be the case if a 'super-regulator' is established.

If those promoting the idea of a global 'super-regulator', to regulate international capital markets, and necessarily as an adjunct or part of that task, capital flows too, this would necessarily have to come under the jurisdiction of the Basle-based BIS, the central bank of the G-10 central banks, which is gradually expanding its relationships with some of the leading developing country central banks.

If the BIS has to undertake this role, it would bring it into conflict and turf-battles with institutions like the IMF, and also many parliaments in the industrialized world and in developing countries too. And it would also bring the BIS into the limelight - something that like the member central banks, the BIS has been avoiding.

Underscoring the lack of knowledge of the causes and consequences of financial crises, White says: "It is instructive to note to note that neither Mexico nor the South-East Asian countries were widely viewed as vulnerable before their respective crises began. In the event, commonly held beliefs that responsible fiscal policies and high domestic savings rates would suffice to prevent financial crises proved sadly wrong.

For example, an examination of 1999 GDP growth forecasts and real effective exchange rates in some of the Asian countries hit by the crisis shows the extent to which the forecasters missed the severity of the Asian downturn as well as the more recent upturn, comments White.

Also, the character of recent financial crises has different in significant ways, and this has implications in the search for practical solutions - such as for bond contracts to include sharing and majority voting, to make it easier that the private sector shares in the costs.

In the Latin American debt crisis of the 1980s, an essentially limited number of banks were involved as creditors with sovereigns as indebted parties - and such bond contracts would have had a limited value. In the Mexican crisis of 1994-95, the debtor was a sovereign, but lending had been through disintermediated markets by tens of thousands of different lenders. And in the more recent East Asian crisis, and subsequently, a relatively small number of banks were dominant lenders, though securities issuance was increasingly significant, with lending essentially to a wide range of private sector entities.

And though such a crisis has not been seen in the post-war period, crises could also be envisaged involving very large numbers of both borrowers and lenders interacting almost exclusively through disintermediated markets as in the 1920s.

"The central point is that measures to prevent the recurrence of the last crisis may not in fact prevent future crises since crises can arise and propagate themselves in very different ways."

And while differences in circumstances do matter in search for solutions, an underlying fact of the crises is "the growing reliance on market-based financing processes as opposed to more traditional intermediated finance" -- as seen in the sharp rise in securities issued by emerging markets, growing use of securitisation in financial markets of industrial countries and the "virtual explosion" in use of derivative instruments, mostly traded in over-the-counter (OTC) markets.

Hence, first, measures to strengthen the system must be comprehensive and cover each of the main pillars of the international financial system - institutions, markets and infrastructure - says White.

Second, policy-makers and regulators must also rely increasingly on market-led processes to provide the discipline required to encourage prudent and stabilising behaviour.

Third, markets do have limitations -- bubbles do occur and market failures do happen -- and the "complementary activities" of regulators and supervisors would continue to be needed to enforce market disciplines.

Finally, whatever measures are taken to strengthen the financial system, these must recognize the international dimension.

"If level playing fields are to be encouraged and regulatory arbitrage avoided, these measures will increasingly have to be the result of international negotiations and agreements."

The spectacular fallout from the Russian crisis and events surrounding the devaluation of the Brazilian real provide no cause to question fundamentally these conclusions, White suggests.

"However, they do serve to strengthen the belief that the dynamics of market behaviour ought to be a source of increasing concern to policy-makers and market participants themselves. At present it is not clear who is responsible for regulatory oversight of markets and the credit excesses to which they might contribute."

And recent experience seems to confirm the strong inter-relationships between macroeconomic instability and financial instability.

"Any strategy for dealing with the instability of financial markets must investigate the extent to which that instability has its roots in macro-economic phenomenon, in particular the excessive growth of credit, and in the choice of an inappropriate exchange rate regime."

In the light of recent developments, the paper notes, concerns have grown that the financial markets may themselves be increasingly important sources of financial instability.

The possibilities are that there may be greater short-run volatility in asset price movements. There may also be enhanced likelihood of longer-term misalignment in asset prices, i.e. deviations from longer-term equilibrium prices. International financial markets themselves may enhance the likelihood of contagion spreading across previously separated markets.

"In fact there are grounds for believing that all three problems may be of greater significance now than previously."

Some of the recent events -- like the Russian debt moratorium and the subsequent difficulties of Long-Term Capital Management Fund (resulting in an organized rescue by the New York Federal reserve -- are consistent with the view that modern financial markets have the capacity to sharply increase short-term price volatility.

The interactions between behaviour of market participants and actions of official sector also suggest that declining policy interest rates in major industrial countries seem to be correlated with periods when investors seem to become relatively less risk-adverse.

White also points out that nominal interest rates in major industrial countries have come down sharply over the last decade, but real interest rates have not fallen much, though investors suffering from money illusion may believe they have. The correlation between expansion of broad money supply relative to nominal income suggests that the discrepancy is most marked in recent years and has been growing in the United States. However, empirical research has not been very successful in finding close relationships between such financial variables and asset prices.

Is there is a private sector contribution to the recent developments in international financial markets?

Trends in spreads on emerging market bonds and their credit rating suggests that investors in markets and institutional lenders have in recent years been pricing risk rather more aggressively than in the past. Equity prices in many countries are certainly difficult to explain using traditional investment criteria - real stock prices, real 'warranted stock prices' and dividends.

"If the price of financial assets is being pushed up, even as excess capacity is driving down the rate of return on underlying assets, this is not a permanently sustainable situation."

The behaviour of financial institutions, White says, reflects two basic causes. Competition in financial services area has increased markedly. Even as profits have been harder to come by, growing concern for shareholder value has meant that managers have come under substantially greater pressure to maintain or expand profit levels.

These developments in themselves may have inclined some financial institutions to engage in riskier endeavours. But closely related to his has been the role of public safety nets, attenuating perceptions of possible costs associated with such risk taking.

Citing the recent experiences in Korea (where explicit sovereign guarantees meant a perception of no credit risk), Mexican and Asian crises where IMF interventions led to liquidity risk being considered minimal, White says that arguably the first result has been the sharp expansion of capital stock in a large number of specific industries worldwide: steel, shipbuilding, automobiles, chemicals, pharmaceutical, electronic products, and commercial property in many emerging markets. In some other industries (e.g. international telecommunication sector) new capacities is just coming on line.

"It is this excess capacity that has driven down prices of such products and materially aided the global process of disinflation which has been so welcome to date."

But the problem is that profits in these sectors are also under seven pressure, and loans taken out to finance capital expansion often cannot be repaid, threatening in turn the viability of many lenders.

Another effect of a period of over-investment is a sharp fall in overall demand as capital adjusts downward - something already evident in south-East Asia and Japan. But the US may also be somewhat exposed to this (as could be seen in the Information Technology industry, which has made a large contribution to US output growth).

Another element is that the greater willingness to take risks may have contributed to the sharp pickup in capital flows to emerging market economies, and the brutality of the turnaround when concerns about riskiness of such investments begin to reassert themselves.

And if capital flows contributed to expansionary excesses on the way in, they also contributed significantly to crisis and recession on the way out. As external financing disappeared for Asian countries with sizeable current account deficits, domestic absorption had to be reduced by whatever amount necessary to respect underlying accounting identities. As trade credit dried up for some countries, the offsetting competitive advantages provided by a lower currency value could not be immediately exploited.

"This precedent," White comments, "makes the current combination of recession and still large current account deficits in Latin American countries worrisome."

As for the contribution of the international markets to contagion across markets and countries, there is little doubt that financial markets are now much more inter-related than before. But it is not clear whether this is a good or bad thing. While individuals now have more ways to cover risks, and shocks may be dispersed quickly across markets, a single market or underlying infrastructure (especially the payments and settlement system) might fail with knock-on effects of significant magnitude.

Moreover, as consolidation in financial services industry leads to a smaller number of firms exercising greater influence over a diverse set of markets, the chances of spillovers that are unwarranted and potentially dangerous also increase.

Financial instability has thus a number of manifestations - volatility, misalignments and contagion. Each may have a number of underlying causes, and these must be known before problems can be rectified. But macro-economic forces, domestic and international, have also contributed to recent, and perhaps some prospective, difficulties. But deficiencies in the operation of the financial systems, domestic and international, have had an unwelcome influence.

It is in this view that the idea of a global international super-regulator has been advanced by some. Arguments supporting this include the globalization of financial markets, breakdown of sectoral distinctions, growing integration and complexity of international financial markets and need for efficient information sharing by all relevant bodies. All this, it is argued, calls for an organization that can see the big picture and do something about it - need for something both comprehensive and fundamentally international.

But there are practical and political arguments against this proposition. At a practical level, oversight and supervision has to be a hand-on affair - an argument used in deciding in Europe that banking supervision should stay at the national level, rather than migrate to the European Central Bank. More practically, could the magnitude of the task faced by a single agency be so great as to be effectively unmanageable.

But the political objections to a super-regulator is also significant. Such a regular setting standards and enforcing them globally would be enormously powerful, and national legislators are not yet ready for this. Nor do national legislatures seem ready to cede the degree of sovereignty needed to make such a super-regulator effective - as shown in the US Congressional antipathy to the IMF and the difficulties faced in obtaining legislation to raise Fund quotas.

The idea of a super-regulator would also violate the principle that internal governance and market discipline should be at the heart of financial oversight, White says. While a super-regulator could operate in this fashion, theories of bureaucracies teaches that they may tend to act in its own interest instead.

However, it is not clear from White's arguments whether this 'principle' about internal governance and market discipline is related to the ideology of the market or more practical considerations.

In the end, White falls back upon and supports the current incremental approach and the various institutions acting in this matter. He also explains the incremental improvements being effected within Basle framework (BIS, Basel supervisors etc). But this does not resolve a problem of public policy, namely, how to get over the fact that such supervisory frameworks are always one step behind, and find themselves trying to lock the stable after the horse is stolen. (SUNS4601)

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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