Regulation of international financial markets and capital flows - some developing-country concerns

The current global financial turmoil has served to underscore the critical need to regulate international financial markets and capital flows to avert future crises. A leading financial expert considers the various reform proposals with particular regard to the concerns of the developing countries.

Yilmaz Akyuz

PAST experience shows that even when monetary and fiscal discipline is secured and a relatively high degree of price stability is attained, unbridled financial markets are capable of generating instability and crises with serious consequences for the real economy, notably jobs and incomes. The global financial turmoil triggered by the sub-prime debacle has shown once again that the Anglo-American view that financial markets regulate themselves is not only wrong but is also highly damaging.

There is now a broad agreement on the need for tighter regulation than has been the case, but views differ about how best to regulate and the degree of regulation. Moreover, regulation of international capital flows is highly contentious. The dominant view still entertained in the mainstream is that once financial markets and institutions are properly regulated there is no need to restrict international capital flows. However, this does not stand against ample evidence that prudential rules do not necessarily bring greater stability to international capital flows, nor can they prevent such flows from inflicting serious damage on an economy (Akyuz 2008).

Several reasons are usually given as to why financial regulation should be international. First, since financial instability often has adverse global spillovers, national regulatory practices should be subject to multilateral disciplines. Second, multilateral rules would provide a level playing field and prevent regulatory arbitrage - that is, business running away from tightly to lightly regulated jurisdictions. Finally, they would reduce the influence of politicians over regulators and give them a certain degree of independence - a concern that is now widely shared after the hands-off approach that the previous United States administration had adopted vis-…-vis financial markets.

While these considerations are basically valid, there are both political and technical difficulties in establishing multilateral discipline in financial regulation and supervision. A supreme international body with fully-fledged regulatory and supervisory powers over all financial institutions is not on the agenda. However, it is increasingly held that global and systemically important institutions should be regulated and supervised internationally rather than nationally. Several proposals have been made for establishing international bodies for credit rating agencies and transnational banks over a certain size.

An option would be to leave the conduct of regulation and supervision to national authorities within a framework established according to the same principles as the World Trade Organisation (WTO). This would involve binding multilateral agreements on a set of rules and regulations for financial institutions including banks, institutional investors, rating agencies, and bond and credit insurance companies. There would be a commitment by governments to implement such rules and regulations through national regulators. Finally, there could be a multilateral body to oversee implementation and impose sanctions for non-compliance, such as denying access of financial firms from non-complying countries to markets of other members.

However, it is still quite unrealistic to expect systemically important countries, including some emerging economies, to give up national policy autonomy to the extent required. It is notable that even the European Union has not managed to establish a unified regulatory system. Furthermore, serious difficulties could be faced in reconciling and integrating different legal systems and conceptual frameworks in arriving at a uniform set of rules for economies at different levels of financial development and with different financial institutions and culture.

More importantly, such an arrangement would carry risks and drawbacks for developing and emerging economies (DEEs). It is not realistic to envisage that a global institution with genuine clout over major advanced economies could be established on the basis of a distribution of power markedly different from that of existing multilateral financial institutions. Thus, it may not be wise to create another multilateral body before solving satisfactorily the governance-related problems that pervade the existing institutions such as the International Monetary Fund (IMF), World Bank and WTO.

Second, there is the familiar one-size-fits-all problem. In all likelihood, rules and regulations to be agreed in such a setting would be shaped by the exigencies of financial markets and institutions of more advanced economies. These would not always be suitable to DEEs. On the other hand, as the experience in the WTO shows, special and differential treatment that may be granted to DEEs may not mean much in practice.

Furthermore, entering into comprehensive multilateral negotiations could open the Pandora's Box of market access in financial services, liberalisation of capital flows and multilateral agreement on foreign direct investment, resulting in further restrictions over policy space in DEEs. The real danger for DEEs is that a process designed to broaden the scope of global governance over finance may end up extending the global reach of financial markets. It is notable that one of the recommendations of a G20 working group on international cooperation was for Financial Stability Forum (FSF) member countries to 'maintain the openness of the financial sector' (G20 2009: p. 7). It is not clear if this is meant to be liberalisation of market access in financial services or if it would apply to new developing-country members of the expanded FSF. But it is a clear sign that global arrangements for financial regulations may entail new obligations for DEEs for opening up their financial sectors to foreign firms.

A less ambitious approach would be to extend the mandate and improve the governance of existing bodies such as the FSF, the Bank for International Settlements, the Basle Committee on Banking Supervision, the International Association of Insurance Supervisors, and the International Organisation of Securities Commissions. Most existing proposals for improving global governance of finance indeed envisage a voluntary process of closer coordination among national regulators, based on an agreed framework within such institutions, rather than a rules-based system with sanctions.

The G20, a grouping of major developed and developing economies, also appears to be moving in that direction, emphasising the need for 'internationally agreed high standards', 'common and coherent international framework, which national financial authorities should apply in their countries consistent with national circumstances' and 'systematic cooperation between countries'. It proposes 'to establish supervisory colleges for all major cross-border financial institutions' (G20 2009: p. 5). The Group has also agreed to transform the FSF into a Financial Stability Board by extending its membership to include all G20 countries and its mandate to the regulation and oversight of all systemically important financial institutions, instruments and markets, including the hedge funds and credit rating agencies.

There are also proposals to give a greater role to the IMF in financial surveillance. However, this role should not be extended to setting regulatory standards or overseeing financial markets and institutions. In this area the task of the Fund is to monitor macroeconomic and financial developments and provide early warning of risks of instability and crises. Its ROSC (Report on the Observance of Standards and Codes) exercises, introduced after the Asian crisis and undertaken as part of Article IV consultations and in conjunction with the joint FSAP (Financial Sector Assessment Program) activities with the World Bank, are meant to help promote global financial stability. However, these activities have been highly ineffective because of several shortcomings in the design and application of codes and standards. Therefore, before the IMF may be given new roles in the financial architecture, it is important to have a reasonably good understanding of the factors that have made existing instruments and mechanisms ineffectual and to remove them through appropriate reform.                                                   

Yilmaz Akyuz is Special Economic Adviser to the South Centre. He was formerly Director of the Division on Globalisation and Development Strategies at the United Nations Conference on Trade and Development (UNCTAD). The above is extracted from his paper 'Policy response to the global financial crisis: Key issues for developing countries' (South Centre, May 2009).

References

Akyuz, Y. (2008). 'Managing Financial Instability in Emerging Markets: A Keynesian Perspective'. METU Studies in Development, 35(10).

G20 (Group of Twenty) (2009). 'Enhancing Sound Regulation and Strengthening Transparency'. Final Report.Working Group 1. Available at www.g20.org.

*Third World Resurgence No. 234, February 2010, pp 29-30