institution building in the financial sector 20050922

INSTITUTION BUILDING

IN THE FINANCIAL SECTOR

© 2005 G20 Secretariat

Editing, design and layout by Communications Development Incorporated,

Washington, D.C.

CONTENTS

PREFACE X

INSTITUTION BUILDING IN THE FINANCIAL SECTOR

—OVERVIEW OF G20 DISCUSSIONS XII

PART I REPORTS TO FINANCE MINISTERS AND CENTRAL

BANK GOVERNORS

REPORT TO FINANCE MINISTERS AND CENTRAL BANK

GOVERNORS—BANCO DE MÉXICO 3BENEFITS AND CHALLENGES OF FINANCIAL DEREGULATION AND

LIBERALIZATION 4

WHETHER FINANCIAL DEREGULATION AND LIBERALIZATION

HAVE STRENGTHENED INSTITUTION BUILDING 6

CENTRAL COMPONENTS OF AN ADEQUATE INSTITUTIONAL

FRAMEWORK FOR THE FINANCIAL SECTOR 7

THE ROLE OF INTERNATIONAL FINANCIAL INSTITUTIONS 12

SUMMARY OF ISSUES IDENTIFIED BY CASE STUDIES 13

REPORT TO FINANCE MINISTERS AND CENTRAL BANK

GOVERNORS—DEUTSCHE BUNDESBANK 17LEGAL FRAMEWORK 17

PAYMENT SYSTEMS 19

DEVELOPING STRONG DOMESTIC FINANCIAL MARKETS 19

ORGANIZATIONAL OPTIONS FOR DISCHARGING SUPERVISORY

FUNCTIONS 22

TECHNICAL ASSISTANCE 24

PART II CASE STUDIES AND CROSS-COUNTRY REVIEWS

AUSTRALIA 29ORIGINS OF FINANCIAL DEREGULATION 29

DEVELOPMENTS AFTER DEREGULATION 31

ii i

THE POLICY RESPONSE 33

BENEFITS OF REFORMS 38

DESIGN OF FINANCIAL REGULATION FRAMEWORK 41

BROADER POLICY LESSONS 43

GOING FORWARD 44

CANADA 47THE FINANCIAL SERVICES SECTOR 47

KEY FACTORS DRIVING CHANGE 47

CHALLENGES FACING THE INDUSTRY AND REGULATORS 50

FINANCIAL INSTITUTION POLICY 52

DEVELOPMENTS IN PAYMENT SYSTEMS 56

ENCOURAGING FINANCIAL MARKETS: A CASE STUDY 59

CHINA 64POLICY MEASURES TO PROMOTE INSTITUTIONAL BUILDING 64

MAJOR ISSUES OF INSTITUTION BUILDING IN THE FINANCIAL SECTOR 66

ROLE OF THE GOVERNMENT 67

ROLE OF THE CENTRAL BANK 68

ROLE OF THE INTERNATIONAL FINANCIAL INSTITUTIONS 69

THE ROLE OF FOREIGN BANKS 69

THE ROLE OF NEW TECHNOLOGY 70

INSTITUTION BUILDING FOR THE CHINESE BOND MARKET 70

IMPACT OF FINANCIAL SECTOR DEVELOPMENTS ON

ECONOMIC GROWTH 73

OUTLOOK FOR INSTITUTIONAL REFORMS IN THE COMING YEARS 75

FRANCE 80THE FIRST STEPS TOWARD LIBERALIZATION BEFORE 1984 80

THE BANKING ACT OF 1984 GAVE THE REAL IMPETUS TO

FRENCH BANKING LIBERALIZATION 81

THE BANKING ACT PAVED THE WAY FOR A STRONGER

BANKING SYSTEM 83

CONTENTS

iv

DEREGULATION ALLOWED GREATER CONCENTRATION AND

THE RISE OF POWERFUL BANKING GROUPS 84

THE REGULATORY FRAMEWORK AND THE ACTIONS OF

SUPERVISORY AUTHORITIES HAVE STRENGTHENED THE BANKING

SECTOR 86

SEPARATE SUPERVISORS—WITH GREATER COOPERATION 88

STRENGTHENING AND SIMPLIFYING 89

ANNEX A FRENCH FINANCIAL LEGISLATION 90

GERMANY 91GERMANY’S MACROECONOMIC AND LEGAL FRAMEWORK 93

PRINCIPLES OF BANKING SUPERVISION 97

NEW MEASURES FOR SAFEGUARDING CLIENTS OF LIFE INSURERS 104

CAPITAL MARKET REFORMS IN THE WAKE OF GLOBALIZATION 105

MAJOR FEATURES OF THE PAYMENT SYSTEM 108

LESSONS AND RECOMMENDATIONS 111

ANNEX A MAJOR REPORTING REQUIREMENTS IN BANKING

SUPERVISION 113

ANNEX B CAPITAL MARKET REFORMS, 1985–2002 115

ANNEX C INFRASTRUCTURE FOR THE TRADING, CLEARING,

SAFE CUSTODY AND SETTLEMENT OF SECURITIES 117

ANNEX D CHRONOLOGY OF THE MOVE TOWARD CASHLESS

PAYMENTS, 1959–2001 119

INDIA 122POST-INDEPENDENCE INSTITUTION BUILDING 122

THE REFORM YEARS: 1991–2004 128

IMPACT OF FINANCIAL INSTITUTION BUILDING 135

SCHEDULED COMMERCIAL BANKS 136

THE FUTURE OF INDIA’S FINANCIAL SYSTEM 142

LESSONS FROM INDIA’S EXPERIENCE 144

CONCLUSION 146

CONTENTS

v

IND ONESIA 148BANKING REFORM 148

NONBANK FINANCIAL INSTITUTION REFORM 152

FURTHER INSTITUTIONAL CHANGES FOR THE BANKS 157

FURTHER INSTITUTIONAL CHANGES FOR NONBANK

FINANCIAL INSTITUTIONS 159

LESSONS 160

CONCLUSION 162

ITALY 165MAIN CHANGES IN THE ITALIAN FINANCIAL SYSTEM DURING

THE LAST THREE DECADES 166

RECENT DEVELOPMENTS IN THE ITALIAN FINANCIAL MARKETS 181

COMPETITION IN THE ITALIAN FINANCIAL SECTOR 186

CONCLUDING REMARKS 187

JAPAN 193DEVELOPMENT OF THE FINANCIAL SYSTEM IN THE HIGH-GROWTH PERIOD 193

THE END OF HIGH GROWTH AND THE BEGINNING OF A

TRANSFORMATION IN THE FINANCIAL SYSTEM 195

PROVISIONAL APPRAISAL 198

REPUBLIC OF KOREA 204IMPROVING FINANCIAL SOUNDNESS THROUGH INSTITUTION

BUILDING 209

ACHIEVEMENTS IN STRENGTHENING THE FINANCIAL SYSTEM 218

THE OUTLOOK FOR FURTHER IMPROVEMENT OF THE

REPUBLIC OF KOREA’S FINANCIAL SYSTEM 222

MEXICO 229PROTECTED FINANCIAL MARKETS (FIRST PHASE: 1970–88) 229

FORTIFYING FINANCIAL INSTITUTIONS (SECOND PHASE:1988–94) 230

CONTENTS

vi

REVAMPING THE FINANCIAL SECTOR IN THE AFTERMATH OF

THE CRISIS (THIRD PHASE: 1995–2000) 233

RECENT INSTITUTIONAL REFORMS (FOURTH PHASE 2001–04) 237

LESSONS FROM THE MEXICAN EXPERIENCE 242

SAUDI ARABIA 248THE GENESIS AND EARLY YEARS 248

CONSOLIDATION AND RESTRUCTURING IN THE 1970S 249

BANKING PROBLEMS AND THEIR RESOLUTION IN THE 1980S 250

CHALLENGES OF THE 1990S—SYSTEMIC STABILITY AND

CONSOLIDATION 253

RECENT LEGISLATIVE CHANGES 254

PROSPECTS FOR THE NEXT DECADE 256

THE WAY FORWARD 257

UNITED KINGD OM 259THE SITUATION IN THE UNITED KINGDOM BEFORE 1997 259

INSTITUTIONAL REFORMS SINCE 1997 260

MONETARY AND FISCAL POLICY REFORM 260

REGULATORY REFORM 261

COMPLEMENTARY SECOND-LEVEL INSTITUTIONAL REFORMS 266

IMPACT OF FINANCIAL SECTOR INSTITUTION BUILDING 268

IMF AND WORLD BANK FINANCIAL STABILITY ASSESSMENT

PROGRAM 269

PERFORMANCE OF THE FSA 269

FUTURE REFORMS 270

CONCLUSIONS 271

UNITED STATES 274INSTITUTIONALIZING TREASURY NOTE AND BOND AUCTIONS 275

THE FEDERAL RESERVE’S BOOK-ENTRY SYSTEM 279

THE FEDERAL RESERVE’S SECURITIES LENDING PROGRAM 284

TRIPARTY AND GENERAL COLLATERAL FINANCE REPOS 288

CONTENTS

vii

EUROPEAN UNION 297OVERVIEW OF MAJOR INSTITUTIONAL CHANGES 298

SOME STYLIZED FACTS ON THE IMPACT ON FINANCIAL

SECTOR DEVELOPMENT 304

FURTHER STEPS IN INSTITUTION BUILDING 306

POLICY IMPLICATIONS 310

FINANCIAL SECTOR STANDARDS AND CODES AND INSTITUTION

BUILDING—INTERNATIONAL MONETARY FUND 315HOW STANDARDS ASSESSMENTS BY FSAPS STRENGTHEN THE

INSTITUTIONAL INFRASTRUCTURE OF THE FINANCIAL SECTOR 316

MAIN FINDINGS FROM STANDARDS AND CODES ASSESSMENTS 318

INSTITUTION BUILDING THROUGH FSAP FOLLOW-UPS AND

TECHNICAL ASSISTANCE 322

FURTHER STRENGTHENING THE ROLE OF STANDARDS

ASSESSMENTS 323

THE EVOLVING INSTITUTIONAL AGENDA FOR SOUND FINANCE

—WORLD BANK 326INSTITUTIONAL UNDERPINNINGS FOR SOUND FINANCE 327

LEGAL INFRASTRUCTURE FOR FINANCIAL SYSTEMS 328

ACCOUNTING AND AUDITING SYSTEMS AND PRACTICES 334

CORPORATE GOVERNANCE 337

WORLD BANK SUPPORT FOR INSTITUTION BUILDING IN THE

FINANCIAL SECTOR 339

PART III G20 WORKSHOP ON DEVELOPING STRONG

DOMESTIC FINANCIAL MARKETS

SUMMARY OF PRO CEEDINGS FROM THE G20 WORKSHOP ON

DEVELOPING STRONG DOMESTIC FINANCIAL MARKETS 347GENERAL SUMMARY 347

CHALLENGES IN THE ABSENCE OF STRONG DOMESTIC

FINANCIAL MARKETS 350

CONTENTS

vii i

FINANCIAL INTERMEDIATION AND ECONOMIC GROWTH 352

THE SEQUENCE OF FINANCIAL LIBERALIZATION AND

SUPERVISORY REFORMS 354

INFRASTRUCTURE BUILDING AND GOVERNANCE 357

BUILDING STRONG LOCAL SECURITIES MARKETS 359

CONCLUDING OBSERVATIONS 362

ix

CONTENTS

PREFACEThe 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

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.

Dr. Guillermo Ortiz Professor Axel A. Weber

Governor President

Banco de México Deutsche Bundesbank

xi

PREFACE

INSTITUTION BUILDING IN THE

FINANCIAL SECTOR

OVERVIEW OF G20 DISCUSSIONSAlthough 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

xii

The objective of this section is to summarize the central messages emerging fromG20 discussions on Institution Building in the Financial Sector. The views expressedhere are the sole responsibility of the authors and should not be considered as theofficial position of the G20.

through deregulation of the domestic financial sector and liberalization

of the capital account have a positive impact on the development of

the financial system, there are also accompanying systemic risks. An

adequate institutional structure is of the utmost importance for min-

imizing such risks. On the other hand, deregulation and liberalization

can play a part in stimulating institution building in the financial sec-

tor, through such channels as the additional market scrutiny that

these policies entail or by highlighting shortcomings in the institu-

tional setting.

It is important to stress that these general conclusions were accompanied

by a word of caution: while the analysis of other countries’ experiences is

indeed very useful, it is far from certain whether the lessons on institution

building from one country can be applied directly to another.

It would be impossible to summarize in a few pages the long list of spe-

cific issues dealt with during the G20 discussions on institution building in the

financial sector. However, the most frequently discussed building blocks of

the institutional framework were provisions aiming at ensuring macro-

economic stability, legal certainty, a reliable payment system, a proper frame-

work for regulation and supervision, an appropriate deposit insurance scheme,

and propitious conditions for implementing new developments in informa-

tion and communication technology. The group also discussed ways to

strengthen financial markets and sequence market reforms. There was little

disagreement among the Group’s members concerning these features:

• Central bank independence and institutional adjustments fostering

the implementation of prudent fiscal policies in the long run (such

as multi-annual public budgets, automatic fiscal adjusters, and rules

and procedures strengthening fiscal responsibility) were seen as play-

ing a major role in macroeconomic stability.

• Financial intermediation and markets cannot function adequately in

the absence of a well functioning legal system. Although many ele-

ments of the legal framework were identified as important, particu-

lar attention was devoted to appropriate collateral and insolvency

legislation and to the work the World Bank is carrying out in this

connection.

• Building strong and efficient payment systems should be a priority in

the institutional development of the financial sector, and the central

bank should be at the heart of these efforts. The development of cash-

DEUTSCHE BUNDESBANK AND BANCO DE MÉXICO

xii i

less payment systems providing generalized access to banks was

underlined as one of the fundamental courses of action in this area.

• The appropriate framework for financial supervision was the subject

of deeper analysis. During the last years, an increasing number of

countries have moved toward integrated supervisory frameworks.

But the Group concluded that it is not possible to identify ex ante a

single best organizational framework for financial supervision—and

that each country should adopt the model that best fits its particular

circumstances. Even so, whether an integrated or decentralized

approach is implemented, the organization of supervisory tasks

should seek to ensure efficiency and accountability of supervisory

agencies.

• Institution building in the financial sector must pay due regard to

the incentive structure for deposit insurance agencies. In particular,

those agencies must not rely on comprehensive government guaran-

tees to avoid moral hazard.

• The establishment of appropriate conditions for the use of modern

information and communication technologies was seen as a major

element in strengthening institution building in the financial sector,

particularly in view of the needs imposed by globalization.

• G20 members attached special attention to the development of strong

domestic financial markets. They stressed that a strong banking sys-

tem acts as a catalyst for developing stable and efficient financial mar-

kets. They thus concluded that developing both a sound banking

system and sound financial markets is preferable to supporting a par-

ticular model. In addition, it was noted that several measures of a

more technical nature support the development of domestic finan-

cial markets. A strong base of institutional investors and policies

aimed at increasing market liquidity were underlined among them.

• The deregulation of the domestic financial sector and the liberaliza-

tion of the capital account must be adequately sequenced. Countries

that are still opening their capital account should proceed on the basis

of sound macroeconomic policies and gradual deregulation of the

financial sector combined with appropriate enhancements of the

supervisory framework.

International financial institutions were seen as having a major responsi-

bility in supporting institution building in the financial sector in their mem-

ber economies. Several channels were identified. The Financial Sector

OVERVIEW OF G20 DISCUSSIONS

xiv

Assessment Programs (FSAPs), the provision of technical assistance, and the

measures directly supporting the development of domestic financial markets—

such as the issue of bonds in local currencies—are the most important among

them. To be useful, FSAPs need to be updated frequently and accompanied by

appropriate technical assistance. In addition, as technical assistance demands

become more sophisticated, support from countries through the provision of

national experts gains importance. Moreover, there is a need to use the

resources available at international financial institutions for technical assis-

tance purposes more efficiently. Finally, coordination among institutions and

countries that provide these services should be further improved.

Despite the efforts by many countries to develop an appropriate institu-

tional framework for the financial sector, the challenges ahead remain huge.

On the one hand, a large number of economies still need to undertake sub-

stantial efforts to reach an adequate stage of institutional development. The

requirements and priority areas vary substantially from one country to

another. On the other hand, building the proper institutional framework for

the financial sector is an ongoing task that must adapt in all countries to the

changing environment.

The G20 discussions helped to identify some of the areas where further

action is likely to be needed. They include the potential for greater interna-

tional cooperation on regulatory and supervisory issues, the challenges posed

by large and complex financial institutions, and the policies needed to foster

corporate debt markets, among others.

All in all, it is our hope that this book will contribute to a better under-

standing of the institutional setting required for establishing stable and effi-

cient financial sectors and of the most important policies needed to support

this process. We sincerely thank all G20 members for their effort, efficiency and

enthusiasm in this exercise over the past two years.

Juergen Stark, Deutsche Bundesbank

Javier Guzmán, Banco de México

DEUTSCHE BUNDESBANK AND BANCO DE MÉXICO

xv

PART I

REPORTS TO

FINANCE MINISTERS AND

CENTRAL BANK GOVERNORS

REPORT TO



PREPARED BY BANCO DE MÉXICO

MORELIA, MEXICO, 26–27 OCTOBER 2003

During the G20 ministerial meeting in India in November 2002, several

finance ministers and central bank governors emphasized the central role of

institution building in the functioning of markets and more generally in eco-

nomic development. Against this background, G20 deputies included in the

2003 agenda the topic “Globalization: The Role of Institution Building in the

Financial Sector”.

In addition to the guidance received from ministers and governors in

selecting this topic, several issues were taken into consideration:

• While strong institutions are required in a range of areas, focus on

institution building should be in an area more in line with the exper-

tise of G20 members.

• Financial markets cannot function adequately without an appropriate

institutional framework, especially with today’s rapid globalization.

• The combination of different levels of development and an ample

variety of experiences provides the G20 with a unique platform to

analyze this issue. A thorough discussion of the group’s experiences

can help build a more solid ground for understanding the role of

institution building in developing the financial sector and more gen-

erally in fostering economic growth.

In this context, G20 members were invited to prepare case studies on their

experience with institution building in the financial sector. Since there are a

variety of views as to what the term institutions includes, it was agreed to con-

ceive of them as “the rules, enforcement mechanisms and organizations that

shape the functioning of markets”. Participants in this project were Australia,

Canada, the People’s Republic of China, France, Germany, India, Indonesia,

Italy, Japan, the Republic of Korea, Mexico, Saudi Arabia, the United Kingdom

3

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.

BENEFITS AND CHALLENGES OF FINANCIAL DEREGULATION AND

LIBERALIZATION

In several countries the costs incurred from financial repression highlight the

benefits of financial deregulation and liberalization. In these cases direct con-

trols of both interest rates and credit gave rise to the stagnation or even decline

of savings and distorted the working of fundamental price signals, as volatile,

negative real interest rates retarded development of a credit culture and appro-

priate risk management.Also, a system of excessive regulations restricted banks’

operational flexibility and their ability to compete, and stimulated riskier lend-

ing with the free portion of banks’ resources, raising costs and affecting the qual-

ity of bank assets. Furthermore, restricted bank financing to the private sector,

REPORT TO FINANCE MINISTERS AND CENTRAL BANK GOVERNORS

4

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

MORELIA

5

environment, this combination of factors caused loan quality to deteriorate.

The implications of inadequately supported financial deregulation and liber-

alization efforts were serious in some countries. In particular, when financial

deregulation and liberalization (especially the opening of the capital account)

coincided with institutional weaknesses, such as an inadequate supervision of

banks or inexperienced management at the helm of national institutions, the

stage was set for a major financial crisis. For this reason, it is of utmost impor-

tance that a robust institutional framework is established before embarking on

financial deregulation and liberalization.

WHETHER FINANCIAL DEREGULATION AND LIBERALIZATION HAVE

STRENGTHENED INSTITUTION BUILDING

Several studies support the notion that financial deregulation and liberaliza-

tion stimulate institution building. In fact, the positive impact of financial

deregulation and liberalization on institution building has worked through

several channels. In some cases the challenges raised by financial deregulation

and liberalization and other policies gave rise to a new wave of financial reforms

aimed at addressing the institutional weaknesses made evident during dereg-

ulation and liberalization. For instance, in some countries the blanket cover-

age on bank deposits (which had given rise to moral hazard problems) was

eliminated, barriers to foreign ownership of banks were relaxed, the frame-

work for supervision was streamlined, the legal framework for bank lending

was strengthened and so on. Institution building was also stimulated as a result

of the additional market scrutiny that came with deregulation and increased

integration with global markets and as a result of knowledge transferred from

foreign financial institutions participating in the local market.

The case of the European Union is particularly useful to illustrate the

stimulus that can be provided by financial integration to institution building.

EU countries have adopted an approach to regional integration that has a

strong institutional component. Thus, integration in the region has been an

external anchor that pressures policymakers to promote better domestic insti-

tutions. Efforts have encompassed a number of layers: political, economic,

legal and regulatory. By defining a set of harmonized minimum requirements

for all member states while simultaneously enforcing mutual recognition of

national practices, a learning process about best practices has been prompted,

which in turn generated momentum for continuous improvement of institu-

tions. In striving for best practice, EU integration has sped institutional

reform, especially in peripheral economies where financial development


6

initially lagged. In the same vein, EU enlargement is currently accelerating

institutional reform in the acceding countries.

Of course, policies can and should influence the institutional structure of

the financial sector directly, not only indirectly through liberalization, and it

would be inappropriate to rely on deregulation alone to generate a stronger

institutional structure. Policies that encourage a strong institutional structure

in key areas are likely a prerequisite for a successful deregulation experience.

CENTRAL COMPONENTS OF AN ADEQUATE INSTITUTIONAL

FRAMEWORK FOR THE FINANCIAL SECTOR

The studies contemplate a long list of institutional elements deemed impor-

tant for sound development of the financial sector. This section refers only to

those that were seen as central in several of them. Divergent views were occa-

sionally observed on the particular features of the institutional framework

required in some of these areas.

Monetary and fiscal policiesIn analyzing the main characteristics of an adequate institutional framework

for the financial sector, several studies emphasize the role of an appropriate

institutional scheme for implementing monetary and fiscal policies.

Central bank independence is considered a fundamental component of

institution building. In particular, central bank independence is seen as a

means to institutionalize the objective of price stability. On this basis, the cred-

ibility of monetary policy serves to establish a stability culture, which renders

important benefits in fostering “long-termism” and low interest rates. Some

countries report that the globalization of financial markets fostered central

bank independence, as a result of factors such as a closer monitoring of the

economy in international markets or the abandonment of nonmarket means

of monetary control, many of which were in the hands of the government

rather than the central bank.

Given the fact that a prudent and efficient management of fiscal policy is

necessary for macroeconomic stability, several countries have introduced or are

considering a number of institutional adjustments aimed at achieving this objec-

tive on a long-term basis. The nature of these efforts varies from one country

to another. In some cases, they implied the development of a multiannual per-

spective for public finances consistent with debt sustainability in the medium

term, the incorporation of automatic adjustors in the budget to help ensure that

approved expenditure ceilings and deficit targets are met or the design of fiscal

MORELIA

7

responsibility laws. In other cases, the government adopted an explicit strategy

to maintain a balanced budget, on average, over the course of the economic

cycle or to keep public net debt as a share of gross domestic product (GDP) at

a stable and prudent level over the economic cycle. The fiscal rules agreed by the

EU countries provide an additional example of the importance attached by

some countries to the institutionalization of sound public finances.

Some countries have been especially concerned about the possibility of

policy coordination failures among the institutions in charge of fiscal, mon-

etary and supervisory responsibilities. In this context, special institutional

mechanisms for coordination and communication among them have been

designed to address this risk.

Supervision of financial institutions and marketsThere are divergent views on the appropriate institutional framework for bank

supervision. At one end of the spectrum, some countries have allocated broad

supervisory powers to the central bank, and there are even recent cases where

laws have been enacted to expand the central bank’s role in other important

sectors of the financial market. At the other end of the spectrum is the grow-

ing number of countries where banking supervision has been separated from

the operation of monetary policy. Several studies report on the creation of a

single regulatory authority entrusted with broad supervisory powers for the

banking and insurance sectors, pension funds and securities market. Some

stress that a framework has been established within which the regulator is

independent of the government in the pursuit of statutory objectives. They

note that international standards recommend the establishment of indepen-

dent regulatory authorities.

It is difficult to determine beforehand whether one of these options (or

an intermediate one) is superior because of the many arguments in favor of

and against them. Supporters of a unified institutional structure for super-

vision point out the potential for economies of scale, its simplicity, the fact

that the traditional functional divisions are no longer very relevant (for exam-

ple, the emergence of financial conglomerates), the prevention of regulatory

arbitrage, improved accountability, reduced costs and better policy coordi-

nation. On the other hand, this structure is criticized on the grounds of the

remaining differences that persist among banks, securities firms and insur-

ance companies. Other limitations attributed to a unified regulator include

its organizational complexity and the risk of creating an excessively power-

ful agency.


8

The studies raise two other issues of financial supervision:

• The importance of an independent supervisory authority. Some stud-

ies conclude that when the supervisory authority does not have full

independence, mechanisms for actual enforcement of remedial mea-

sures against weak banks have limited effectiveness, notwithstanding

the existence of relevant provisions in regulations.

• Globalization has important implications for financial regulation and

supervision. Some studies note that globalization has been accom-

panied by structural changes, including the consolidation of banks,

intensified competition, internationalization of financial activities

and the establishment of mixed financial groups and conglomerates.

Thus, financial regulators and supervisors have been confronted with

a rapidly evolving environment and numerous challenges. The latter

include the need to update regulations to keep pace with financial

market developments and strengthen cross-border cooperation in

prudential supervision, financial stability and crisis management.

A common concern raised in the studies with regard to deposit insurance

relates to the need to avoid the moral hazard that may be linked to this type of

institution. The consensus view is that to avoid moral hazard, deposit insur-

ance must not rely on comprehensive government guarantees. The role of risk-

adjusted deposit insurance premiums and of the principle of system

beneficiaries contributing to the insurance fund are also stressed. Some coun-

tries also emphasize that the authorities must encourage banks to identify and

master financial crises as far as possible by their own means. In this context, one

country reports that its central bank does not even assume any precommitted

lender of last resort function in order to avoid moral hazard. Thus, any direct

involvement in addressing a financial crisis is decided on an ad hoc basis, reflect-

ing an attitude of “constructive ambiguity”. In smaller banking systems, with a

handful of banks, this strategy could be less credible. This calls for strong super-

visory safeguards to help contain any liquidity problems as early as possible.

Two different views are observed in the studies on the role of deposit insur-

ance schemes before an economic crisis. In one country unlimited backing of

banking liabilities was seen as a moral hazard that contributed to excessive

expansion of bank liabilities. After the crisis erupted, the decision was made to

gradually lift the blanket coverage of bank deposits. In other cases, to restore

public confidence and avoid bank runs during the emergence of the crisis, it

was decided to introduce a full blanket guarantee of bank deposits. However,

it must be stressed that even in the latter cases either a deposit insurance

MORELIA

9

institution with limited guarantee coverage was established once the crisis was

overcome, or this is an objective of the authorities for the long term.

Strengthening of domestic capital marketsThe development of viable domestic capital markets that enable borrowers

(both private and public) to fund themselves in their local currency and in

longer-term maturities is fundamental for sound economic development. Well

developed domestic capital markets could potentially insulate the economy

from some of the effects of global financial shocks by providing more stable

and secure sources of liquidity. The ability to borrow in domestic currency

may also be an important factor in assisting a smooth transition to a liberal-

ized financial sector.

All the studies touching on this issue report a fundamental role of the

central bank, in cooperation with the Ministry of Finance and other public

agencies, in fostering an active domestic money market. The primary empha-

sis in the early stages of this process has been on the development of a Treasury

bill market, to an important extent as a means to place the central bank in a

better position to conduct monetary policy. Some countries also report a pos-

itive influence of globalization on the domestic debt market. Interest rate

deregulation required the existence of a risk-free yield curve in the government

securities market and a vibrant money market able to transmit the monetary

impulses from the central bank. Notwithstanding the emphasis put on facil-

itating the implementation of monetary policy, the establishment of a money

market has also been seen as a means to foster better markets for other secu-

rities and to channel funds where they are most needed.

Several technical measures have been adopted to support the development

of a local debt market. These include more frequent auctions of Treasury bills

and a gradual increase in the amounts issued, granting permission to banks and

brokerage houses to submit bids at public auctions for Treasury bills, the devel-

opment of a book-entry system for securities and of a securities lending pro-

gram, the appointment of “primary dealers”or “market makers” to enhance the

liquidity of fixed rate securities in secondary markets by making continuous

bid-ask offers in exchange for certain privileges, permission for foreign

institutional investors to invest in domestic securities and the development of

local institutional investors, such as pension and mutual funds.

In general, the development of an efficient Treasury bill market stimulated

the expansion of an active market for corporate debt paper and led to the intro-

duction of new products. Nevertheless, several countries, including some


10

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 systemsThe 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 frameworkLegal 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.

MORELIA

11

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.

TechnologySeveral 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.

THE ROLE OF INTERNATIONAL FINANCIAL INSTITUTIONS

The important role of international financial institutions in developing the

institutional framework for the financial sector, and specifically that corre-

sponding to recommendations from a Financial Sector Assessment Program


12

(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.

SUMMARY OF ISSUES IDENTIFIED BY CASE STUDIES

The evidence included in the studies prepared for this project support the

notion that financial deregulation and liberalization can have an important

beneficial impact on the size of the financial system and its allocative effi-

ciency. But several studies warn that financial deregulation and liberalization

are also accompanied by risks. So the necessary preconditions, including the

required institutional setting, must be in place before embarking on a move

in this direction.

Given the interrelations among policies in different areas, possible syner-

gies of financial system reforms with other policies must be considered at an

MORELIA

13

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

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

MORELIA

15

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

REPORT TO



PREPARED BY THE DEUTSCHE BUNDESBANK

BERLIN, GERMANY, 20–21 NOVEMBER 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.

LEGAL 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

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

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.

DEVELOPING STRONG D OMESTIC FINANCIAL MARKETS

Strong domestic financial markets are essential for economic growth and devel-

opment since they enhance the collection and allocation of domestic savings,

contribute to preventing capital flight and enable borrowers to resort to longer

term maturities. In addition, they help prevent financial crisis by attracting

BERLIN

19

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


20

a complete yield curve. In addition, efforts should be directed at

reducing foreign currency–denominated or exchange rate–linked

debt in order to curb currency mismatches. Furthermore, collateral-

ized debt obligations can bolster the development of domestic capi-

tal markets. In this context, the German Pfandbrief has been referred

to as a possible model for developing local bond markets in emerg-

ing market economies. Its main attraction is a high degree of investor

protection.

• Third, deputies noted that it could not be argued that either finan-

cial intermediaries or securities markets are more conducive to eco-

nomic growth. Developing both sound banking sectors and sound

financial markets is preferable to supporting a particular model.

Fostering intermediaries as well as markets also enhances the diver-

sity of funding. This could be helpful if access to any particular source

of financing were lost. Deputies also emphasized that foreign direct

investments in the financial sector could contribute to fostering the

performance of local financial systems.

• Fourth, the standards and codes devised by international financial

institutions and other agencies, including the World Bank’s

“Principles and guidelines for effective insolvency and creditor rights

systems”, provide valuable assistance to countries seeking to

strengthen their institutional framework. Deputies mentioned in par-

ticular that improved transparency of economic policy and data

should facilitate the monitoring of currency mismatches and that

such balance sheet problems should be taken into account by pru-

dential supervision from both a micro and a macro perspective. Since

many countries have meanwhile adopted internationally recognized

standards and codes, attention now needs to focus more strongly on

implementation.

• Fifth, deregulating the domestic financial sector and liberalizing the

capital account can provide a major stimulus to developing sound

and deep financial markets. Administrative controls of financial

transactions ultimately weaken the financial sector and retard eco-

nomic growth. But countries that quickly deregulated and liberalized

their financial sector have often encountered serious economic and

financial distress as well. A prudent approach would be to pay atten-

tion to an adequate sequencing. Generally speaking, to prevent

adverse consequences from market-oriented reforms, policymakers

BERLIN

21

should not prioritize measures that appear to be cheap and easy to

implement, while neglecting useful institutional reforms which

might be more time-consuming and costly. More specifically, coun-

tries still opening their capital account should proceed on the basis

of sound macroeconomic policies and gradual deregulation of the

financial sector, combined with appropriate enhancements of the

supervisory framework. Experience has also shown that countries

seeking domestic monetary autonomy while substantially liberaliz-

ing their capital account should increase the degree of exchange rate

flexibility accordingly.

ORGANIZATIONAL OPTIONS FOR DISCHARGING SUPERVISORY

FUNCTIONS

With the dividing lines between different types of intermediaries and their finan-

cial products becoming more and more blurred, deputies considered the rela-

tive advantages of organizational options for discharging supervisory functions.

The traditional approach of assigning the supervision of banks, insurance com-

panies and markets to separate agencies can bring about overlaps and gaps in

the allocation of supervisory responsibilities.An integrated framework could be

better positioned to ensure efficient supervision. Indeed, similar products and

services must not be treated differently depending on the intermediary provid-

ing them.An integrated approach could also advance the harmonization of reg-

ulation, reducing incentives for developing products and services or designing

firms with the sole purpose of lessening the regulatory burden.

In addition, an integrated approach should be better able to form an over-

all risk assessment of a conglomerate on a consolidated basis and to detect weak-

nesses that could affect the stability of the entire financial system. In particular,

assuming increasing linkages between financial sector businesses and products,

an integrated supervisory framework might be able to react to emerging prob-

lems more flexibly. An integrated system could also be better placed to build

supervisory capacity as the recruitment and retention of qualified staff might

be facilitated by offering a wider spectrum of careers and providing better train-

ing facilities. Last, the overall regulatory burden imposed on firms could be

reduced by avoiding duplications of reporting and on-site inspections.

Some deputies pointed out, however, that an integrated supervisory

regime has not yet lived through periods of serious market stress. So, no final

answers can be given on the advantages of integrated supervision. Moreover,

the scope for enhancing efficiency by integrating supervisory tasks might be


22

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.

BERLIN

23

In theory, an argument against central bank involvement in financial sec-

tor supervision advances a potential conflict between the central bank’s inter-

est in maintaining the stability of individual banks or the banking system as

a whole and its monetary policy objectives. But deputies argued that central

banks, whether formally involved or not, will always, in practice, pursue the

double objective of fighting inflation or deflation and maintaining financial

stability. It is up to them for their liquidity support not to raise conflicts

between monetary policy requirements and financial stability objectives. That

said, the role of central banks in the supervisory framework can vary between

a prominent one and a relatively low profile. If a central bank is not formally

involved in supervision, an exchange of information on banking issues would

be an advantage.

Deputies concluded that, while financial sector developments in the past

two decades have strengthened the argument for an integrated supervisory

regime, arguments for decentralized approaches remain valid. In particular,

since supervisory regimes have to accommodate country-specific settings, there

is no blueprint or a single best approach. Even so, whether integrated or not,

the organization of supervisory tasks should pay due regard to ensure effi-

ciency, operational independence and accountability of supervisory agencies.

TECHNICAL 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

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.

BERLIN

25

PART II

CASE STUDIES AND

CROSS-COUNTRY REVIEWS

AUSTRALIAFinancial liberalization in Australia provided a competitive stimulus to the

financial sector, enhancing technical, allocative and dynamic efficiency. It also

provided the necessary conditions for Australia to become more closely inte-

grated with the global economy, as parallel policy changes aimed at opening

the economy to world markets. The Australian experience suggests that there

are synergies in reforming different policy areas and gives insights into the

appropriate sequencing of reforms. Given the fast rate of change in global

markets, the reform task is ongoing. The challenge for policymakers is to keep

pace with market developments to ensure that the regulatory environment

continues to be relevant and appropriately balanced.

The Australian financial system evolved in five stages. The first was the

introduction of financial institutions during the early colonial period in the

19th century, when the influence of British institutions was a driving force.

The end of that period was marked by the 1890s depression, which saw a major

rationalization of Australia’s financial institutions. The start of the modern era

of financial regulation can be traced to banking legislation in 1945 and the

establishment of Australia’s first central bank.

In more recent times, Australia has seen two major waves of financial

reform. The first, in the 1970s and 1980s, involved a major deregulation exer-

cise that transformed Australia’s financial system. In keeping with other pol-

icy measures aimed at opening Australia to increased trade, investment and

international competition. A second wave of reform in the 1990s sought to

address new regulatory issues in the postderegulation period. Financial sec-

tor reform occurred not in a vacuum—but in the context of a significant era

of reform of the Australian economy.

ORIGINS OF FINANCIAL DEREGULATION

The postwar regulatory system essentially sought to achieve its monetary

and supervisory goals through direct restraints on the activities of banks.

The regulatory regime in place during this period restricted banks’ opera-

tional flexibility and ability to compete. For example, interest rate ceilings

on deposit accounts restricted their ability to attract funds. Similarly, lend-

ing was restricted through guidelines on trading bank approvals. Savings

banks were constrained in ability to lend for housing by the requirement to

hold a majority of assets in cash, government securities or deposits with the

central bank.

29

Nonbank financial intermediaries grew to fill the gaps caused by restraints

on banks—for instance, merchant banks to service corporations and building

societies to service the home lending market. The market share of commercial

banks declined from 1955 to 1980, and bank assets declined as a share of gross

domestic product (GDP). This had important implications for the conduct of

monetary policy, which relied on direct controls on banks and caused pru-

dential concerns.

Steps toward deregulation were taken in the 1960s and 1970s to bolster

the position of banks and to begin to establish the means to exert influence

on the broader financial system. For instance, maximum rates on large over-

drafts were removed in 1972, and interest rates on certificates of deposit were

freed in 1973, giving banks some scope to manage their liabilities. But regu-

lation was very much focused on the domestic market and competition among

domestic institutions.

Freeing regulation in some areas had the effect of increasing pressure on

the regulations that remained. By the 1970s these pressures were being aggra-

vated by the interest-sensitive nature of capital flows—largely reflecting the

establishment of merchant bank subsidiaries of foreign banks, which had

access to funds from their overseas parents. These volatile capital flows,

together with a pegged exchange rate, complicated efforts to control domes-

tic liquidity and aggravated the effects of differential regulation between

various parts of the financial system. The need for the central bank to fund

any shortfall in raising government debt added to problems with liquidity

management.

Against this background, the government did a major review of the

Australian financial system—the Campbell Committee inquiry in 1979—the

first major wave of financial sector reform. This inquiry responded not just to

the increasing importance of nonbank financial institutions and the difficul-

ties with operating monetary policy. It also answered the need for a review and

assessment of the range of ad hoc regulatory changes in the 1960s and 1970s.

The Campbell Committee looked at the regulation, control and structure

of the financial system to promote efficiency while ensuring the stability of the

system. It recommended the removal of regulations that undermined efficiency,

such as interest rate controls and lending restrictions, and the strengthening of

prudential oversight to bolster stability. In its report, the committee argued that

deregulation would increase efficiency of the financial system in three ways:

• It would improve allocative efficiency by removing the barriers to the

flow of savings into the highest-yielding investments.

CASE STUDIES AND CROSS-COUNTRY REVIEWS

30

• It would increase operational efficiency by reducing the very wide

interest rate margins maintained by the Australian banks.

• It would enhance dynamic efficiency in the form of greater financial

innovation to meet the needs of consumers of financial services.

The committee suggested removing ceilings on interest rates on bank

deposits, lifting maturity restrictions on bank deposits, introducing a tender sys-

tem for selling government securities, relaxing portfolio controls on savings

banks, relaxing capital controls and removing restrictions on the entry of foreign

banks. These recommendations were implemented in the first half of the 1980s.

A further recommendation was floating the Australian dollar. At the time,

there was recognition in Australia and elsewhere that it was not possible to

pursue an independent monetary policy while defending a fixed exchange rate

with mobile capital. This broader concern, along with short-term pressures

from speculation against the Australian dollar, led to the floating of the cur-

rency in 1983.

As an entire generation had known only a highly regulated environment,

the government allowed time for businesses, the bureaucracy and the general

community to absorb the Campbell Committee’s report. The report of the

Review Committee (the Martin Report) strongly endorsed the major recom-

mendations of the Campbell Committee and from then on the government’s

commitment to deregulation was unreserved. In rapid sequence, major rec-

ommendations of both reports were implemented.

DEVELOPMENTS AFTER DEREGULATION

The rapid deregulation in the first half of the 1980s sparked equally rapid

change in Australia’s financial sector. From 1983 to 1988 the amount of cap-

ital in the sector rose from A$4.5 billion to A$20 billion, the number of bank-

ing groups operating in Australia from 15 to 34 and the number of merchant

banks from 48 to 111.1 Credit also expanded rapidly, growing by 147 percent

between 1983 and 1988, but this brought some unanticipated problems.

Lowering of barriers to entry into financial markets increased competi-

tion, which in turn facilitated technological innovation and enhanced con-

sumer choice. Deregulation improved the efficiency of the sector by focusing

activity toward innovation and away from the unproductive activity of cir-

cumventing outdated regulations.

Deregulation accelerated the forces of globalization on the Australian

market. While technological change lowered the costs of crossborder trans-

actions, deregulation removed impediments to such transactions, allowing

AUSTRALIA

31

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

Foreign banks also carried a significant level of nonperforming loans dur-

ing the recession of the early 1990s. The share of nonperforming loans to total

assets peaked at 12 percent for the foreign bank sector, twice the peak in the

broader system. The actions of the domestic banks to protect market share

might have contributed to foreign banks taking on riskier business. The

domestic banks began reacting to the possibility of competition from foreign

banks through mergers, acquisitions and increased lending in the early 1980s,

well before deregulation and before any foreign banks actually entered the

market.

Managing country currency riskThe move to a floating exchange rate in 1983 came in response to pressure

from capital inflows, not capital outflows, as is more frequently the case in

other countries. Even so, there was a learning phase for agents to recognize and

manage currency mismatches.

Faced with new financial freedoms in the immediate postfloat period,

some agents began to borrow unhedged in foreign currencies to take advan-

tage of significantly lower interest rates overseas. In particular, many farmers

and small businesses borrowed substantial amounts in Swiss francs. When the

exchange rate subsequently fell sharply, (by about 40 percent) in 1985 and

1986, these borrowers faced large losses, and many went out of business. The

immediate issue that led to the problems of the Swiss franc loans was risk

recognition. Publicity surrounding the problems of farmers educated the cor-

porate sector about the risks and the need to manage them.

Although Australia worked through this period without a fullblown bank-

ing crisis, the ramifications lasted for some years. The economy’s recovery

from the 1990–91 recession was slowed by the need for banks and corporates

to repair their balance sheets. At the same time, the Australian Banking

Industry Inquiry in 1991 was set up to examine concerns about the perfor-

mance of the banking sector in a deregulated environment. It sought to

strengthen the supervision of banks.

THE 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

AUSTRALIA

33

1996 to establish a new inquiry to review these developments, to consider the

factors likely to drive further change in a more global environment and to

make recommendations for possible further improvements to the regulatory

arrangements.

Financial system reform—the second waveIn 1996 the government commissioned the Financial System Inquiry, the

Wallis Inquiry, to make recommendations on regulatory arrangements that

would respond to the developments of the previous decade and ensure an

efficient, responsive, competitive and flexible financial system. The underly-

ing objectives were:

• To promote greater efficiency through enhanced competition.

• To maintain confidence and stability in the financial system while pre-

serving the ability to respond to innovation and market developments.

The inquiry found that the intensity of prudential regulation should be

proportional to the degree of market failure that it addresses, but should not

involve a government guarantee over any part of the financial system.

Fundamentally, it is the responsibility of the board and management of finan-

cial institutions to keep financial promises to consumers. Prudential regula-

tion and supervision should seek only to add an additional discipline by

promoting sound risk management practices for firms and by providing for

early detection and resolution of financial difficulties.

The inquiry considered that while prudential regulation is warranted in

certain limited circumstances, its more intense forms would need to be wound

back over time, and the regulatory focus shifted toward the conduct of mar-

ket participants and the disclosure of information.

The financial regulation framework recommended by the Wallis Inquiry

in its Final Report of March 1997 was intended to be flexible in the face of

ongoing changes in the financial sector. Evolution in the market required a

shift in regulatory philosophy toward more reliance on a function-based sys-

tem and away from institution-based arrangements.

The government accepted a majority of the inquiry’s recommendations

(Costello 1997). The key recommendation was a new organizational frame-

work for the regulation of the financial system. The inquiry recommended

a model of regulation based on functional objectives, with three “peaks”—

a single prudential regulator, a regulator for conduct and disclosure and an

institution for systemic stability and payments. The regulatory framework

before the inquiry was based on a sectoral approach, where different


34

regulatory institutions had responsibility for specific industries in the finan-

cial sector.

The reforms built on the previous regulatory framework, which was based

on four institutional regulators, and replaced them with three agencies estab-

lished on functional lines.

The regulators were given substantial operational independence from the

government in administering legislation and in dealing with particular cases

of prudential supervision or conduct and disclosure. They have a clear char-

ter of objectives and accountabilities.

Monetary policyIn 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.

AUSTRALIA

35

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 policyFollowing 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.

Trade policy and competition policyIn addition to deregulating its financial sector, Australia reformed other sec-

tors of its economy in response to the more outward orientation of the domes-

tic policy framework that began in the 1970s. Lowering tariff barriers and

rationalizing industry assistance in the 1980s provided further impetus to the

globalization of the economy and transformed the traded goods sector. As a

result, Australia’s trade intensity (exports plus imports of goods and services

as a share of GDP) rose from 30 percent of GDP in 1983/84 to 43 percent in

2001/02.

Increased international competition also led to pressure to reform the

nontraded goods sectors important to international competitiveness because

they supplied inputs to exporters. The National Competition Policy intro-

duced in the 1990s brought together a range of reforms of key infrastructure

at the commonwealth and state levels to enhance competition and improve the

regulation of monopolies.


36

Globalization’s changing of the nature and definition of markets had par-

ticular implications for mergers policy, which had to recognize import com-

petition and the international competitiveness of firms seeking to increase

their market share. This has taken place in an environment where the general

mergers policy has been overlaid with a “four pillars” policy, which prohibits

mergers between Australia’s four major banks.

Tax reformAustralia’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.

AUSTRALIA

37

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.

BENEFITS 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 benefitsThere 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

39

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.

Reduced costs of regulationEvidence compiled by the Wallis Inquiry indicated that the direct cost of reg-

ulation in Australia was higher than in a sample of other jurisdictions. In part,

these higher costs were attributed to new regulation introduced following the

Campbell Report. Much of this regulation did not fully anticipate the pace of

developments in financial markets.

More recent data on the direct costs of regulation indicate that costs in

Australia have fallen relative to other selected countries. The improvement in

the direct cost of regulation likely reflects the streamlining of regulatory

arrangements following the Wallis Inquiry. The reforms ensured that the reg-

ulatory framework was coherent, duplication was minimized, and unneces-

sary imposts were eliminated.

Output benefitsWhile 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

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 performanceDuring 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


40

Table 1

Average annual growth rates, 1970–2000 (percent change)

GDP growth1970–1980 1980–1990 1990–2000 1996–2000

Australia 3.2 3.2 3.5 4.2OECDa 3.4 3.0 2.5 3.2

GDP growth per capita1970–1980 1980–1990 1990–2000 1996–2000

Australia 1.5 1.7 2.3 3.0OECDa 2.5 2.3 1.8 2.6

a. Weighted average.Source: OECD 2003a.

uptake of business-transforming information and communication technolo-

gies in a macroeconomic environment that supported steady growth and

strong investment.

The cross-country evidence also shows that a sophisticated, effectively

regulated financial sector is an important contributor to growth. As the OECD

notes, “there is growing evidence that a well developed financial system is an

important aspect of a favorable environment for growth, especially in a period

of the rapid spread of a new technology when they can promote new, innov-

ative enterprises” (OECD 2003b). The Australian experience with financial

sector liberalization, underpinned by stable and supportive macroeconomic

policies and structural reforms, contributed to sustained economic growth

and reduced Australia’s susceptibility to economic shocks.

DESIGN OF FINANCIAL REGULATION FRAMEWORK

Several factors influence the effectiveness of financial sector regulation and

subsequent changes to regulation. Australia’s experience suggests that:

• The financial regulation framework is more effective if the objectives

of regulation are clearly defined and the framework can adjust to

developments in the financial sector.

• A balance needs to be struck, when determining the appropriate level

of regulation and transparency, between achieving stability and secu-

rity and promoting competition, innovation and efficiency. The

reporting requirements of financial institutions and the regulations

governing the behavior of the supervisory authorities need to be

consistent with the requirements of the relevant international stan-

dards and codes to ensure international competitiveness and best

practice.

AUSTRALIA

Table 2

Productivity growth rates in Australia, annual average (percent)

Labor Multifactor

Second half of the 1990s 3.7 2.01990s 2.9 1.41980s 1.4 0.41970s 2.8 1.3Long-term average (since 1964/65) 2.4 1.1

Source: Australian Bureau of Statistics, Catalogue Number 5204.0.

41

• The benefits of reforms to financial regulation may take some time

to be realized, perhaps requiring complementary reforms in many

areas and sectors.

• Once a reform process has begun, it gains its own momentum. It

is important that governments maintain an ongoing commitment

to reform, including periodic reviews that look at the operation of

the financial system holistically, so that the effects of ad hoc or

piecemeal efforts can be assessed and revised as necessary to ensure

complementarity.

The shift in financial regulation from the institutional form of the service

provider to a functional-based approach following the Wallis Inquiry im-

proved the flexibility of the regulatory framework. It provided for a more

coherent and streamlined approach to regulating financial service providers,

including conglomerates. This has been reflected in improvements in the rel-

ative costs of regulation in Australia.

Financial stabilityMany 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

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.

BROADER POLICY LESSONS

The Australian experience also demonstrates that reforms are interrelated. For

example, the deregulation of the financial sector contributed to pressures to

rethink the conduct of monetary and fiscal policy. It also put pressures on

other areas of regulation. This suggests that the desirability of broad-based

reform takes account of synergies among different policies at an early stage.

That said, there is no exact blueprint for reform—and politically there are

limits to the amount of reform that can be implemented at any one time.

Governments must take opportunities as they arise because they can realistically

AUSTRALIA

43

champion only a small number of causes. Moreover, in the absence of perfect

foresight, reform will always be an iterative process.

There are, however, some general considerations that can be drawn from

the Australian experience:

• Adjustment costs might have been lower if prudential reform had

occurred at the same time as restrictions on competition were

removed.

• Reforms to the financial sector, in conjunction with the removal of

controls on capital flows and exchange rates, can have significant

effects on the conduct of fiscal and monetary policy. In Australia,

these changes helped bring about pressure for an independent mon-

etary policy and a medium-term fiscal policy that reflected the impact

of the budget on national saving.

• Reforms to one area of regulation have flow-on effects to other areas

of regulation. In Australia, financial sector reforms added to pressure

for changes to other areas of regulation, such as competition policy,

corporate law and taxation law.

GOING 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

45

cross-guarantees, has demonstrated that supervision would in some

cases be more appropriately conducted on a group basis. The

Australian Prudential Regulation Authority has introduced a frame-

work for the prudential supervision of conglomerates that include an

authorized deposit-taking institution.

• Monitoring the structure of financial regulation to ensure that it

remains efficient and effective in the face of a changing global

environment.

• Considering possible approaches to increase policyholder protection.

The failure of the HIH Insurance Group generated renewed discus-

sion of the merits of establishing systematic arrangements to protect

the interests of policyholders when an institution fails.

• Seeking greater international cooperation on financial sector regulatory

issues. The regulation of financial services has been responding to the

implications of globalization through improved communication and

coordination between financial regulators across countries. The bene-

fits of closer relationships between regulators are likely to increase as

the provision of financial services becomes more internationalized.

NOTES

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.

REFERENCES

Australian Bureau of Statistics. Various years. Australian System of NationalAccounts. Catalogue Number 5204.0. Canberra.

Comely, B., S. Anthony, and B. Ferguson. 2002. “The Effectiveness of FiscalPolicy in Australia—Selected Issues.” Presented at The Impact of FiscalPolicy, Bank of Italy Research Department Fiscal Policy Workshop, March21–23, Perugia, Italy.

Commonwealth of Australia, Department of the Treasury. 1999. Making Trans-parency Transparent: An Australian Assessment. Canberra.

———. 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 theHouse of Representatives, by the Hon. Peter Costello, Treasurer of the Houseof 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.” KPMGAustralia, 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 InvestorFinance.” 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: ReserveBank of Australia.


46

CANADAFinancial 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.

THE FINANCIAL SERVICES SECTOR

The financial services industry has been undergoing significant change that

Freedman and Goodlet (1998a, 2002) document in two technical reports that

analyze key developments affecting the industry and its regulators. The pace

and scope of change appear to be greater than ever. Also noteworthy is the

uncertainty faced by financial service providers attempting to develop strate-

gies to maintain profitability and long-run viability.

KEY FACTORS DRIVING CHANGE

The first report by Freedman and Goodlet (1998a) identifies the driving forces

behind the developments of the previous decade: changes in technology, com-

petition, and household demographics. These changes have contributed to

challenges being faced by the industry, including the importance of size and

the choice of the range of services and products being offered. Freedman and

Goodlet’s second report (2002) emphasizes the roles of economies of scale

and scope,2 mergers and concentration, and strategy and the impact of infor-

mation technology on service delivery.

47

TechnologyPerhaps 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

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.

CompetitionA 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

CANADA

49

institutions have also faced an important increase in competition arising from

nonregulated financial service providers, which have entered a variety of loan

and borrowing areas where they have effectively competed with traditional

regulated lenders. There is also potential for nonfinancial entities, such as soft-

ware firms and telecommunication companies, to begin delivering payment

services and fund management.

Household demographicsTrends 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.

CHALLENGES FACING THE INDUSTRY AND REGULATORS

A prominent issue facing the industry is the importance of size. It is impor-

tant to distinguish between the business lines of financial service providers and

the size of a financial institution as a whole. The literature has steadily evolved

in this area, with the most recent literature appearing to suggest that

economies of scale in a number of business lines extend further than previ-

ous empirical work indicated. Evidence of this is seen in the growth of finan-

cial firms that specialize in only a few product areas (so-called “monolines”).

These firms exploit economies of scale in process-intensive or information-

intensive activities such as credit card processing. The growing importance of

outsourcing in certain activities is also in part a sign of significant economies

of scale.

The benefits from the overall size of a financial institution come from

different sources, such as an increased possibility of economies of scope in

institutions with multiple business lines and the ability to engage in activities

that require more capital. In addition, diversification across business lines can

smooth revenue and profit flows.


50

The prevalent view among financial institutions is that Canadian markets

for financial services are too small for even the largest financial service

providers to operate efficiently in certain lines of business. Large Canadian

financial service providers believe that they must operate as North American

entities. Indeed, there are several recent examples of Canadian financial ser-

vice providers implementing such a strategy. Key issues for these financial ser-

vice providers are the extent of the economies of scale in their areas of

specialization and whether they can achieve the size needed to realize

economies of scale in order to compete with large U.S. financial service

providers. Regulatory restrictions may limit the ability of financial service

providers to realize these economies.

Questions remain regarding the importance of economies of scope or

synergies. The nonfinancial sector has experienced waves of conglomeration

and divestiture as views about the benefits and costs of size change. Whether

the financial sector will experience a similar pattern is unknown.

The factors driving change in the financial services sector also have impor-

tant implications for how the sector is regulated. Just as financial institutions

are trying to develop their strategic direction, policymakers are grappling with

the nature and type of regulation that would best function in the evolving

financial landscape. They have to worry about such issues as competition, the

appropriateness of commercial-financial links, and the relative reliance on

disclosure and market discipline as opposed to direct supervision. The first

technical report by Freedman and Goodlet (1998a) examines several of the key

challenges facing policymakers and regulators.

Given the changes in financial service providers, governments may rely

less on the traditional forms of direct solvency regulation to protect financial

service providers’ creditors and more on market discipline, supported by dis-

closure requirements. This shift may be driven by the significant improve-

ment in the oversight of payment and other clearing and settlement systems

where systemic risk could be present, the costs of direct regulation relative to

its benefits, increased use of holding companies that permit separation of

financial service providers’ activities and thus permit use of different types of

regulation, the sale of financial services or products to residents by financial

service providers from outside the country and not subject to domestic reg-

ulation, and increased outsourcing of financial service providers’ activities.

Another topic of discussion has been the relative merits of the functional

approach to regulation as opposed to traditional institutional regulation.

While many models of functional regulation exist, one of the more widely

CANADA

51

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.

FINANCIAL INSTITUTION POLICY

Canada has tended to implement regulatory change continuously and grad-

ually, with banking legislation historically reviewed every 10 years, and more

recently every 5 years. This may have helped the country respond to the unan-

ticipated aspects of changes in the financial sector more quickly than coun-

tries where legislative changes occur infrequently. Daniel (2002) chronicles

several significant legislative developments in Canada since the early 1990s.

Since 1992, when significant changes were made to the statutes governing fed-

eral financial institutions, the practice of regularly reviewing the legislation

governing Canada’s banks has been extended to reviewing the legislation gov-

erning all federal financial institutions. Most recently, in October 2001, key

technical regulations aimed at reforming Canada’s financial sector came into

force as part of Bill C-8.

Legislative developments, 1992–2001Several important legislative developments for financial institutions occurred

from 1992 to the 2001 passage of Bill C-8. In 1992 the process of updating the

regulatory framework for federal financial institutions became more formal

when the government incorporated sunset clauses that required legislation to


52

be reviewed at five-year intervals. The 1992 legislation continued to remove

the legal barriers separating the activities of various types of financial insti-

tutions. It involved significant amendments to the statutes governing banks,

trust companies, and insurance companies, and dealt with the powers of finan-

cial institutions, ownership, and ways of managing self-dealing and conflicts

of interest.3 The amendments allowed federal financial institutions to diver-

sify into new lines of business through financial institution subsidiaries and

through increased in-house powers.

As a result of the 1992 amendments, Canadian financial institutions were

able to develop into conglomerates that operated in a variety of financial areas.

But limitations on investments in nonfinancial businesses meant that they

could not become universal banks with downstream links to commercial com-

panies. Also as a result of the 1992 changes, reserve requirements on banks

were phased out over two years, ending the unequal treatment of institutions

competing for the same business.4

In 1997 a review of financial institutions legislation was used to determine

whether the substantial changes implemented in 1992 had produced the intended

results. The legislative framework was found to be generally working well, and

only minor changes were implemented to update and fine-tune the legislation.

The 1997 amendments also dealt with consumer privacy and tied selling.

March 1999 legislation allowed Canada’s largest mutually owned life

insurance companies (those owned by insurance policyholders) to convert to

public stock companies owned by shareholders through a process known as

demutualization. Before this, four of the five largest Canadian life insurance

companies were mutually owned. Within a year, Canada’s five largest life insur-

ance companies were stock companies.

In June 1999 legislation was passed allowing foreign banks to operate in

Canada without having to set up Canadian-incorporated subsidiaries. Foreign

banks could establish full-service branches, which are not permitted to take

deposits of less than C$150,000, or lending branches, which are not permit-

ted to take any deposits from the public and are restricted to borrowing only

from other financial institutions. Except for these restrictions, foreign bank

branches have essentially the same business powers as foreign bank sub-

sidiaries and domestic banks. An important reason for allowing foreign banks

to enter Canada via branch banks is to enable them to use their larger home

capital base to support lending in Canada. Overall, the foreign bank entry

regime offers foreign banks greater flexibility with respect to how they provide

financial services in Canada.

CANADA

53

Following the failure and near-failure of several nonbank financial insti-

tutions in the late 1980s and early 1990s, the federal government reviewed the

prudential regulation and supervision of Canada’s financial sector. The gov-

ernment emphasized the importance of early intervention and resolution

when institutions experienced financial difficulty. The review resulted in leg-

islation in June 1996 that gave a clearer statutory mandate to the Office of the

Superintendent of Financial Institutions (OSFI), the prudential supervisor of

federal financial institutions. OSFI’s mission includes safeguarding policy-

holders and depositors from undue loss, and its supervisory framework

emphasizes the importance of early intervention in the affairs of troubled

institutions. OSFI’s role is not to provide a failure-proof system. Rather, the

ultimate responsibility for running safe and sound institutions rests with the

management and board of directors of each institution. The 1996 legislation

also allowed the Canadian Deposit Insurance Corporation, which had a sys-

tem of flat-rate deposit-insurance premiums, to develop a system of risk-based

premiums—that is, a premium system that is differentiated on the basis of the

risk profile of individual deposit-taking institutions.

The 2001 legislationIn 1996 the Canadian government also established the Task Force on the

Future of the Canadian Financial Services Sector to comprehensively review

Canada’s financial sector and provide advice on public policy issues for devel-

oping an appropriate framework. The work of the task force shaped the next

round of amendments to the financial sector legislation. The task force’s final

report in September 1998 identified several measures that could help finan-

cial institutions better meet future challenges and offered 124 recommenda-

tions for enhancing competition and competitiveness, improving the

regulatory framework, and empowering consumers. After the task force com-

pleted its review, the government released a policy paper outlining the policy

framework that became the basis for the 2001 financial sector legislation.

The 2001 legislation was wide-ranging. Its objectives were to promote the

efficiency and growth of the financial sector, foster greater domestic compe-

tition, improve the regulatory environment, and empower and protect con-

sumers. Certain provisions in the legislation broadened the scope of

investments permitted for federal financial institutions in-house or through

subsidiaries, providing them the opportunity to innovate and bring new prod-

ucts to customers. The legislation also made it easier for these institutions to

have significant partners in joint ventures and enhanced regulated financial


54

institutions’ ability to meet increasing technological and competitive chal-

lenges from, for example, unregulated and “monoline” firms specializing in a

single line of business.

Additional detail is provided here on a few of the key changes from the

new legislation. Since 1967 Canada’s bank ownership regime was based on

the principle of wide ownership of major banks. The 2001 legislation main-

tained widely held ownership for banks but provided for an ownership regime

based on size. Banks were classified as large, medium, or small, based on their

equity size. Large banks are required to be widely held, as they were before. To

offer more flexibility for entering alliances for joint ventures, however, the

definition of “widely held” was expanded to allow an individual investor to

own up to 20 percent of any class of voting shares and 30 percent of any class

of nonvoting shares of a large bank.5 Generally, medium banks could be closely

held, while small banks were not subject to any ownership restrictions.

To increase organizational flexibility, the new legislation allowed banks to

incorporate one or more Canadian banking subsidiaries and permitted regu-

lated, nonoperating holding companies for bank and insurance companies.

Market participants have indicated that the extent to which institutions adopt

a holding company structure depends on a range of considerations. The

Superintendent of Financial Institutions has recently published its proposed

bank holding company regulations.

The 2001 legislation continued the limits on financial institution invest-

ment in commercial enterprises. But new rules relaxed the investment regime

somewhat. A broader range of investments was permitted, including more

opportunities for investment in e-commerce.

The government has acknowledged that large-bank mergers can be a

viable business strategy. Two issues that are relevant for public policy include

the size required to be globally competitive and the importance of maintain-

ing domestic competition. Along with the 2001 financial sector legislation,

the government set out a review process for merger proposals among large

banks and bank holding companies with more than C$5 billion in equity.

Subsequently, the government decided to seek further input on reviewing

merger proposals prior to releasing revised merger review guidelines.

Consumer-related issues were also a focus of the 2001 financial sector

legislation. It established the Financial Consumer Agency of Canada to enforce

the consumer-oriented provisions of the federal financial institution statutes,

monitor the financial service industry’s self-regulatory initiatives to protect the

interests of consumer and small businesses, promote consumer awareness,

CANADA

55

and respond to general consumer inquiries. It can impose monetary penalties

for contravention or noncompliance with consumer-related statutes. The

agency reports to the Minister of Finance.

DEVELOPMENTS IN PAYMENT SYSTEMS

Freedman and Goodlet (1998b) discuss two major developments in recent

years related to large-value payments in Canada.6 The first is the development

of a system for handling large-value payments, which provides certainty of set-

tlement for participants and intraday finality for recipients of funds trans-

ferred through the system. Unlike other G10 countries, the system is not a

real-time gross settlement system, but it has all the essential attributes of one.

The second major development is the Payment Clearing and Settlement Act’s

requirement that the Bank of Canada exercise formal oversight of major pay-

ment and other clearing and settlement systems to control systemic risk. More

recently, legislative changes that affect the breadth and role of the Canadian

Payments Association have been adopted.

The large-value payments systemSignificant efforts around the world have aimed at developing and improving

electronic clearing and settlement systems that handle large-value payments

and securities and foreign exchange transactions. In part, these efforts have

been driven by the need to efficiently process the sharp increases in the vol-

ume and value of such transactions. The key public policy objective in this area

is systems that are both efficient and safe. For systems that handle large val-

ues and can therefore generate large credit and liquidity risk and systemic risk,

the focus had increasingly been on safety (controlling risks so that systems can

withstand adverse shocks and are governed by reliable and transparent legal

frameworks).

Under the auspices of the Bank for International Settlements, the central

banks of the G10 countries developed a set of minimum standards for domes-

tic large-value clearing and settlement systems. The mechanism used in most

countries for certainty of settlement and finality of payment to ultimate receivers

in systems that handle large-value payments is the Real-Time Gross Settlement

(RTGS) system.An RTGS system permits a payment to be completed only if the

sending institution’s account has enough funds at the central bank to cover the

payment. But RTGS system arrangements can be costly to participating insti-

tutions. Partly as a result of this, there was an interest in developing large-value

payment systems that combined the risk-control of an RTGS system with the


56

CANADA

57

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

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.

Payment systems legislationThe Bank of Canada took the lead in working with the private sector to

develop appropriate risk containment mechanisms in the LVTS and other

major clearing and settlement systems in Canada. This was partly because

poorly designed systems could have generated significant liquidity risks for

participants and would likely have involved the Bank of Canada helping

resolve disruptions. Until July 1996 the Bank of Canada’s oversight of these sys-

tems was informal. After the Payment Clearing and Settlement Act (PCSA)

passed in July 1996, the Parliament of Canada formalized the Bank of Canada’s

oversight role in clearing and settlement systems to control systemic risk.

Under the PCSA, the Bank of Canada reviews all eligible clearing and set-

tlement systems for their potential to pose systemic risk, designates systems

with the potential to create systemic risk as subject to the act, and oversees

them continually for the appropriate control of systemic risk. If the governor

of the Bank of Canada believes that a system can pose systemic risk, it may be

designated as subject to the act, provided that the minister of finance is of the

opinion that doing so is in the public interest. The system will then have to

demonstrate that it has adequate risk control mechanisms to control systemic

risk. Systems handling small-value payments (either as individual payments

or aggregate payment obligations) are unlikely to be subject to the act since

they do not typically pose systemic risk. But the Bank of Canada will continue

to monitor them for changes in their situation. By contrast, systems that han-

dle large-value payment obligations are much more likely to generate systemic

risk and hence much more likely to be subject to the act.7,8

The act limits the Bank of Canada’s regulatory role to oversight of systems,

and not to regulation of financial markets or to supervision of individual finan-

cial institutions. It also provides greater legal protection to netting arrange-

ments and settlement rules. For example, the act’s provisions, when combined

with recent amendments to federal insolvency legislation, recognize the legal

enforceability of netting for both transactions handled by clearing and settle-

ment systems and for certain other transactions among financial institutions.

More generally, an important objective of the PCSA is to increase the certainty

that the legal arrangements governing a clearing and settlement system’s oper-

ations will produce the expected outcome in periods of financial stress.


58

As Daniel (2002) discusses, the 2001 legislative package also introduced

some important changes for the Canadian Payments Association, a non-

profit association created by an act of parliament in 1980. It owns and oper-

ates Canada’s domestic currency payment systems, through which all

noncash payments ultimately settle. The new legislation extended eligibil-

ity for membership in the Canadian Payments Association, which already

included the Bank of Canada, chartered banks, and other deposit-taking

institutions, to life insurance companies, securities dealers, and money mar-

ket mutual funds. The revised Canadian Payments Act (CP Act) provided the

minister of finance with certain oversight powers over the association. A

nonstatutory body called the Payments Advisory Committee was formed to

coordinate the Bank of Canada’s oversight responsibilities under the PCSA

with the minister’s oversight activities under the CP Act, and to address pay-

ment system issues in general.

ENCOURAGING FINANCIAL MARKETS: A CASE STUDY

A viable domestic capital market is key to enabling public and private domes-

tic borrowers to fund themselves in their local currency and in longer-term

maturities. Nowlan (2001) reviews the Bank’s of Canada’s initiatives to develop

an active money market in the 1950s and 1960s. Canada’s situation may be

similar to the challenges some emerging countries face with the development

of domestic markets. For example, Canada was a relatively small open econ-

omy reliant on foreign trade.

The Bank of Canada’s primary emphasis was the development of the

Treasury bill market so that it would be in a better position to effectively con-

duct monetary policy. As fiscal agent for the government of Canada, the Bank

of Canada, along with the Department of Finance, also had a strong desire to

promote longer-term capital markets in order to provide the government with

low cost and stable financing. By taking the necessary steps, Canada was able

to face the challenges of financing large fiscal deficits in later years.

Initiatives to foster an active money marketBy the early 1950s, Canada had many years of experience from borrowing in

both domestic and international markets, which offered a solid framework

for a domestic bond market. By contrast, the market for Treasury bills was

almost entirely limited to chartered banks and the Bank of Canada from 1935

to 1952. A short-term corporate paper market was also practically nonexistent

before the early 1950s.

CANADA

59

Beginning in 1953, steps were taken to encourage the growth of Canada’s

money market. The principal objective was to broaden the market for Treasury

bills and other short-term paper by encouraging larger investment dealers to

hold inventories and be willing to make markets. The first steps were to intro-

duce a weekly auction of Treasury bills and gradually increase the amount

issued. At the same time, the Bank of Canada introduced arrangements for

purchase and resale agreements with several investment dealers, encouraging

them to take a “jobbing” (or inventory) position in Treasury bills and other

short-term government of Canada securities.

In 1954 further action was required because dealers were relying heavily

on the Bank of Canada’s purchase and resale agreements facilities to finance

their inventories. After extensive consultation with commercial banks, and

with the cooperation of banks and dealers, a new short-term financing vehi-

cle, called day-to-day loans, was introduced into the Canadian market. Day-

to-day loans were highly liquid assets for the banks, which they began to use

to adjust their cash reserves. The purchase and resale agreement facility was

used infrequently from that point on.

The 1954 revision to the Bank Act was also key in the development of

Canada’s money market. A new system of calculating minimum required bank

reserves held at the Bank of Canada was introduced, which required banks to

maintain a minimum monthly average of 8 percent of their Canadian dollar

deposits. This change, along with the banks’ more extensive use of day-to-day

loans to adjust their cash reserves, stimulated the Treasury bill market. In 1956,

following extensive consultation, banks agreed to maintain a minimum liquid

asset ratio of 15 percent of statutory deposits (that is, a secondary reserve ratio of

7 percent in addition to the 8 percent cash reserve ratio). This had an important

bearing on the underlying demand for Treasury bills as the banking system grew.

A direct result of these initiatives was that the amount of outstanding

Treasury bills grew substantially. The initiatives also helped the market for

other short-term instruments to grow. The next major development took place

in June 1962, when bankers’ acceptances were officially introduced in Canada

as part of the effort to encourage a more active money market. Once again,

the original guidelines were developed through extensive consultation among

banks, investment dealers, and the Bank of Canada. The bankers’ acceptances

market grew slowly in the early 1960s, in part due to high stamping fees

charged by the banks, and secondary trading was very limited. But subsequent

changes enhanced the liquidity of the bankers’ acceptances market and helped

it grow. Other regulations and governing legislation were amended as required,


60

and by the end of the 1960s, the foundation had been laid for a growing,

vibrant money market in Canada.

Subsequent developmentsFollowing 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

CANADA

61

Canada. However, the environment is now dramatically different. The move-

ment toward a more globalized economy presents challenges to public author-

ities as they strive to pursue policies that preserve and enhance the continued

efficiency and competitiveness of capital markets.

NOTES

1. Recent developments in the financial system are regularly surveyed in theBank of Canada’s Financial System Review, published in June and December ofeach year. This and other relevant material on the financial system may be foundon 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 increasein the size and breadth of its activities.

3. Self-dealing refers primarily to transactions between a financial institutionand 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, andits 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 paymentsand clearing systems, see the box entitled “Clearing and Settlement Systems inCanada” 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 theBank 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 settlementsystem designated under the PCSA if the governor believes that its participationposes, or is likely to pose, a systemic risk or an unacceptable risk to the Bank ofCanada (see Daniel 2002, p. 8).

REFERENCES

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: PastChanges and Future Prospects.” Technical Report 82. Bank of Canada,Ottawa.


62

———. 1998b. “The Canadian Payments System: Recent Developments inStructure and Regulation.” Paper prepared for 34th Annual Conference onBank Structure and Competition, May, Federal Reserve Bank of Chicago,Chicago, Ill.

———. 2002. “The Financial Services Sector: An Update on Recent Develop-ments.” Technical Report 91. Bank of Canada, Ottawa.

Nowlan, George. 2001. “Initiatives to Develop Canadian Capital Markets: A CaseStudy.” Bank of Canada, Ottawa.

CANADA

63

CHINAFinancial 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.

POLICY MEASURES TO PROMOTE INSTITUTIONAL BUILDING

China’s financial system reform in the past two decades has been character-

ized by two main institutional innovations: the changes from a planned finan-

cial system to a market-oriented financial system and from a one-tier banking

system to a two-tier banking system. The spectrum of institutions has become

more diversified with the establishment of 10 joint-stock commercial banks,

100 city commercial banks and a large number of urban credit cooperatives,

trust and investment companies together with finance companies, financial

leasing companies and fund management companies.

The institutional reform process can be divided into three stages.

Preparation and strategy exploration: 1979–84The prominent features of the financial system at this stage can be summarized

as separating central banking from commercial banking by establishing a

64

two-tier banking system, establishing specialized commercial banks serving

different industries and introducing a deposit-based model of bank growth.

Framework construction: 1985–96At this stage a series of new arrangements and a primary framework for

market-based financial operations were introduced.

• The legal status of the central bank was established with the promul-

gation of the Central Bank Law in March 1995 and the Regulations

on Monetary Policy Committee in 1997.

• The institutional structure was diversified, including the develop-

ment of nonbank financial institutions, the establishment of several

insurance companies, the fast growth of the securities industry, the

start-up of the Shenzhen and Shanghai Stock Exchanges and the

granting of market access to foreign financial institutions.

• Significant progress was made in financial deregulation, including

the separation of commercial banking from policy banking by estab-

lishing three policy banks in 1994. The Commercial Banking Law in

1995 encouraged competition among banks, improving the capital

management system, introducing an asset/liability ratio regulatory

framework and strengthening internal controls.

• Macro financial management relied more on indirect adjustment

than direct control, with extensive application of monetary policy

instruments. The focus of supervision of commercial banks shifted

from credit ceilings to a comprehensive set of prudential ratios.

• Stock exchanges, interbank markets and bills markets began to

operate.

Adjustment and consolidation: 1997–presentThe development of a buyer’s market entailed considerable adjustment and

consolidation.

• Transferring the nonperforming assets of commercial banks to newly

established asset management companies.

• Improving the segregated financial supervisory system by establishing

the Securities Regulatory Commission, Insurance Regulatory Commis-

sion and Banking Regulatory Commission—and replacing 32 provin-

cial branches with nine regional branches of the central bank.

• Accelerating capital market development by improving its functions

and expanding market capitalization.

CHINA

65

• Accelerating restructuring of the state-owned commercial banks and

putting their ownership reform on the agenda.

• Rectifying the financial order to prevent financial risks.

• Stimulating domestic demand and combating deflation by imple-

menting sound monetary policy.

• Expanding the scope of financial service and initiating a consumer

credit market.

• Creating the conditions for universal banking services through exten-

sive cooperation among banking, insurance and securities industries.

MAJOR ISSUES OF INSTITUTION BUILDING IN THE FINANCIAL SECTOR

The sequencing of institution building in the financial sector differs from coun-

try to country, but some of China’s experiences deserve mention. First, the gov-

ernment should base the content and speed of reform on macroeconomic

stability. Second, adjustment in the financial sector should be consistent with

that of the real economy. Third, internal adjustment should not lag far behind

the process of opening. Fourth, a gradual approach should be adopted. The

government should take into account the possible economic and social conse-

quences, as well as the time frame for the domestic markets to adapt to the

new system and for enterprises to improve their professional skills.

A model of limited opening and gradualism was an inevitable choice for

China because of its basic economic situation and the development stage of

its financial market. Such world famous economists as Professors Ronald

McKinnon and James Tobin suggested that China adopt gradual liberalization—

and gradually integrate with international financial markets.

The relationship between financial opening and financial securityChina’s decision to join the World Trade Organization (WTO) signifies a step

forward in opening the financial sector to the outside world. The era of rigid

financial control will come to an end. Coupled with the advance of the e-econ-

omy, financial opening and liberalization will have a great impact on current

financial systems, especially on the financial regulatory framework. This indi-

cates the importance of financial security, which requires a sound domestic

financial sector and stable liberalized financial markets.

The disadvantage of domestic banks competing with foreign banksCompeting with large international banks, Chinese banks are generally in a

disadvantaged position. The restructuring of state-owned banks has yet to


66

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 hazardThe 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.

Weak financial infrastructureBusiness growth of Chinese banks has been constrained by the weak infra-

structure and practices for loan classification, accounting, auditing and pay-

ment and settlement. For instance, the nonperforming loans of domestic

banks have long been defined following traditional criteria as overdue loans,

default loans and bad loans. This static classification method, quite different

from international accepted methods, cannot reflect the true quality of loans.

In recent years, a five-category classification method has been advanced thanks

to the advocacy of the central bank and the endeavors of commercial banks.

Slow progress in market-based interest rate reformSince interest rates are not adequately determined on a market basis, their signals

for the supply and demand of funds are not fully effective, sometimes having a neg-

ative influence on the pricing and risk management of commercial banks.

ROLE OF THE GOVERNMENT

Supervision and regulation from the government have strong influence on

the behavior of microeconomic entities. To mitigate risk and encourage

CHINA

67

competition, the supervisory authorities adjust financial frameworks and

promulgate supervisory regulations. But banks may also initiate new finan-

cial activities and create new operating models, such as new organizational

structures or new financial products, beyond the existing supervision

boundary. The authorities can regard this as avoiding financial supervision,

so they work out further regulatory measures to follow the new develop-

ments ideally by balancing the costs and benefits.

Intervention by the government in different ways and for different pur-

poses has different effect on the arrangement of reform. An exogenous inter-

vention of the authorities on the financial industry would cultivate the

exogenous features of the institutional reform, which would put external pres-

sure on the financial institutions. Such a reform would be thus less forceful in

improving microeconomic performance.

ROLE OF THE CENTRAL BANK

The status and responsibility of the People’s Bank of China as the central bank

was legally confirmed by the promulgation of the Central Bank Law in 1995.

With dual responsibilities for monetary policy and financial supervision, it has

designed and implemented a serious of financial reform programs under the

leadership of the State Council and with collaboration of relevant govern-

ment ministries. In designing reform programs, the People’s Bank of China

has learned from valuable experiences of the developed economies and fol-

lowed the principles of market economy. But it has never neglected the spe-

cific situation in China. For instance, China has enjoyed strong balance of

payments position after achieving current account convertibility of the

Chinese currency in December 1996, resulting in a stable exchange rate and

sustained growth of foreign exchange reserves.

As international experience shows, capital account convertibility requires

a stable macroeconomic environment, a healthy financial system, effective

financial supervisory framework and enduring national economic strength.

Some emerging economies in Asia, such as the Republic of Korea, Malaysia and

Thailand, have abolished controls on capital account transactions and moved

to full convertibility of their currencies. But China still sticks to the gradual

approach in promoting capital account convertibility. Its deficiencies in eco-

nomic fundamentals call for prudent liberalization.

This approach put China in a better position to confront the Asian finan-

cial crises. And it helped in preventing a confidence crisis on Chinese econ-

omy that would otherwise have led to competitive currency depreciation.


68

This contributed to financial stability not only in Asia but also in the whole

world.

ROLE OF THE INTERNATIONAL FINANCIAL INSTITUTIONS

The International Monetary Fund, World Bank and Bank for International

Settlements have played active roles in financial restructuring in China by

introducing international standards and good practices and providing policy

advice and personnel training in various areas. And since its WTO accession

China has taken active measures to increase its transparency and meet rele-

vant international standards and guidance. Efforts have been made to increase

the transparency of macroeconomic statistics, fiscal policy, monetary policy,

banking information disclosure, as well as the securities and insurance indus-

tries. There has also been progress in promoting good governance structures

and implementing international accounting standards. In general, these mea-

sures have gained wide international acclaim.

THE ROLE OF FOREIGN BANKS

Over the past 20 years, foreign financial institutions, mainly foreign banks

have been important in opening the Chinese financial industry—channeling

inflows of foreign funds and promoting institution building.

The growth of lending by foreign banks has accelerated in recent years, with

more than half the loans supporting manufacturing. Foreign banks also bring

overseas customers to the Chinese market, promoting foreign direct investment.

Foreign banks also help mitigate financial repression in China, establish

a sound financial system and enlarge the contribution of the financial sector

to economic development. They also help realize a cycle of financial deepen-

ing and economic development by promoting competition, demonstrating

advanced technology and management skills to domestic banks and training

Chinese employees.

More important, foreign banks facilitate the development of the domes-

tic capital market by engaging in the investment and securities business. They

urge Chinese regulatory authorities to comply with international standards

and reduce government intervention. They also set good examples for Chinese

banks on how to do business in the international financial markets.

But foreign banks can be a double-edged sword. The growing market

share can bring shocks to Chinese banks, speed the transmission of interna-

tional financial crises and reduce the capability of the central bank to use tra-

ditional monetary policy instruments to manage the economy.

CHINA

69

THE ROLE OF NEW TECHNOLO GY

Competition for online financial transactions may bring a huge shock to the

traditional business of the financial industry. Regulations for online banking

service have yet to be put in place, and the same may apply to regulations for

security certification and modern payments. The gap is considerable between

China and developed countries in using information technology for quality

control on credit assets or for financial risk prevention. Formulating relevant

policies and regulations should aim to promote the healthy development of

online banking services in China.

Chinese domestic banks would face even more challenges from online

banking. Foreign banks, with their strong portfolios and rich experience, could

expand their market shares quickly through online banking and weaken the

advantage of domestic banks in geographic coverage. Commercial banks in

China thus need to develop information technology to reduce the cost of man-

agement and business operation, explore online banking business and pro-

mote nonbank financial institutions.

The substantial changes in financial systems and technologies pose great

challenges to China’s financial and supervisory system. Nonbank financial

institutions or even nonfinancial institutions can avoid supervisions by swift

developing online financial services. That is why the opening of financial mar-

kets and the development of Internet-based financial services will constitute

big challenges to both the monetary authority and the financial supervisors.

INSTITUTION BUILDING FOR THE CHINESE B OND MARKET

Before 1997 China’s bond market mainly comprised exchange-based bond

transactions and over-the-counter (OTC) transactions of bearer’s Treasury

bonds at banks. Different trading terms in the two markets prevented trans-

actions between them. Volatility of the stock markets leads to the volatility of

the price of government bonds traded on the stock exchanges, and therefore

negatively affects the issuance and trading of government bonds.

After a request from the central bank in 1997, commercial banks retreated

from the exchanges. The government bonds entrusted by the commercial banks

at the exchanges were transferred completely to the China Government

Securities Depository Trust & Clearing Co. And the outright and repurchase

transactions of securities were executed by using government bonds, central

bank financial bills and policy financial bonds. China’s bond market has been

reshaped to consist of interbank market, exchange market and an OTC mar-

ket. Since 1998 the interbank bond market has become the major one in China.


70

The interbank bond market is also an OTC market for institutional

investors to trade bonds on a wholesale basis. A majority of book-entry

Treasury bonds and all policy financial bonds are issued and traded on this

market. The trading is quote-driven and executed case by case at a negoti-

ated price. The trading system of the national interbank lending center pro-

vides pricing information, settles the bond transaction and handles

registration through the China Government Securities Depository Trust &

Clearing Co. In June 2003 the outstanding balance of bonds traded in the

interbank market was 2,750 billion yuan—1,480 billion yuan in Treasury

bonds, 1,030 billion yuan in policy financial bonds and 240 billion yuan in

central bank bills.

The exchange market is the marketplace for institutional and individual

investors to trade bonds. Trading is order-driven and executed at matched

prices. Bonds listed on the exchange include Treasury bonds, corporate bonds

and convertible bonds. In June 2003 the outstanding balance of bonds traded

at exchanges was 363.5 billion yuan—330.8 billion yuan in Treasury bonds and

32.7 billion yuan in corporate bonds.

The OTC market has two segments. One is for the Ministry of Finance to

issue bearer Treasury bonds to individuals and enterprises. The other is both

for the Ministry of Finance to issue and for individuals and enterprises to

trade book-entry Treasury bonds. For the latter, commercial banks trade with

investors at the prices they offer through their outlets, providing deposit and

clearing services to investors.

Roles of the government and the central bank in bond market developmentThe 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

CHINA

71

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.

Positive implications of bond market developmentThe bond market supported the implementation of proactive fiscal policy and

facilitated the issue of Treasury bonds and policy financial bonds. From

1998–2002, Treasury bonds issued by the Ministry of Finance totaled 2,158.6

billion yuan, and financial bonds issued by the policy banks totaled 929 bil-

lion yuan.

The bond market provided a solid foundation for the central bank to

exercise indirect financial management. Open market operations have become

the most important instrument for the central bank’s day-to-day monetary

policy operations since 1998. The bond market is also conducive to market-

based interest rate reform. After the establishment of interbank bond market,

repo rates were completely determined by both trading parties, while the

issuance rate was determined through public bidding. The central bank’s suc-

cessful deregulation of interest rates in the interbank market has provided

useful experience for further steps in interest rate reform.

In addition, the bond market made the portfolio adjustments of financial

institutions much easier. Previously, China’s commercial banks had rather

simple balance sheets, with only loans on the asset side and deposits on the

liability side. Bond holdings began to account for an increasing proportion of

commercial banks’ total assets, which to some extent contained the rising risk

originated from dominance of loans in the total assets and helped improve

asset quality. And active trading on the bond market has improved commer-

cial banks’ liquidity management.

Further bond market developmentThe objective of China’s bond market is to establish a nationwide unified

market for all financial institutions, corporate investors and retail investors,

including various submarkets with specific functions. Such a market is to be

mainly founded on an OTC wholesale market complemented by the exchange

retail market. But to develop the bond market further, it is crucial to improve

the bond market infrastructure: establishing credit rating agencies for the

bond market; improving market-based issuing practice, increasing the sup-

plies and products of bond issues; unifying the segregated bond market;

establishing market intermediaries and improving liquidity in the secondary


72

market (bond derivatives may be introduced at a proper time to provide

hedging instruments for bond traders); and improving the bond depository

and settlement system.

IMPACT OF FINANCIAL SECTOR DEVELOPMENTS ON ECONOMIC GROWTH

With the volume of financial assets rising from 438 billion yuan in 1980 to

25 trillion in 1999, the aggregate financial assets to gross domestic product

(GDP) ratio jumped from 1.07 to 3.20 (figure 1).

Financial assets consist of bank deposits and loans, stocks, bonds and

insurance premiums. With the rapid growth of the money market and capi-

tal market, deposits and loans of financial institutions continued to be the

dominant financial assets, even though their proportion declined from 86

percent in 1991 to 77 percent in 1999. Equities, bonds and insurance premi-

ums accounted for only 17 percent of the total by 1999.

Development of direct financing and indirect financing markets providingfinancing sources for enterprisesAs the role of government in providing financing gradually faded out, the

intermediation function of the banking sector started to be more important

(figure 2). With the deepening of financial markets, enterprises resort more

often to banks for credit. With stronger intermediation, household savings

are a major source of national savings, and bank lending is a major source of

enterprise financing.

CHINA

73

1999 1995 1990 1985 1980

Percent

Figure 1. Trend of the financial assets/GDP ratio, 1980–99

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Monetization of the economy increased sharplyUsing the M2/GDP ratio as a measure of an economy’s monetization,

Professor Ronald McKinnon analyzed the gap in financial deepening between

developed and developing countries and the process of financial deepening in

developing countries. He suggests that as finance deepens, the M2/GDP ratio

rises in developing countries. And since China’s reform and opening to the

outside world, its M2/GDP ratio climbed rapidly (figure 3). China’s ratio is

now similar to those of Japan and the United Kingdom, but higher than those

of the Republic of Korea and the United States.

Two reasons were given for the rising trend in China’s M2/GDP ratio. One

is the continual monetization of the economy. Professor Yi Gang made this

hypothesis and found supporting evidence of money in circulation. Since the

beginning of reform and opening of the market, the monetization of transac-

tions has become more common. Goods that used to be provided by the gov-

ernment at low prices or free of charge began to be traded at market prices, and

goods that used to be inaccessible in the market became available. The role of

money as the medium of exchange has become more significant, and the

demand for money has grown accordingly.

The second reason is the rapid growth of quasimoney. The proportion of

household income in national income has kept growing, and households have

become the most important source of deposits. Meanwhile, due to limited

investment choices, household investments are confined largely to bank

deposits.


74

1999 1995 1990 1985 1981

Percent

Figure 2. Financing sources for enterprises, 1981–99

0

10

20

30

40

50

60

70

80

Domestic credit

Foreign funds

State budget

Self-finance and others

OUTLO OK FOR INSTITUTIONAL REFORMS IN THE COMING YEARS

China’s only choice is to accelerate its financial reform, further open the finan-

cial sector, improve the competitiveness of China’s financial institutions and

create a sound liberalized financial environment.

With China’s entry into WTO, the financial industry faces great chal-

lenges. The financial supervisory system falls behind regulatory requirements.

The underdeveloped financial market constrains rational resource allocation

and sound macroeconomic management. The wholly state-owned commer-

cial banks have yet to be transformed to be modern commercial banks. And

there are risks in the rural financial system.

China will thus have to improve the conduct of monetary policy, reform

state-owned banks, improve rural financial services, speed the development

of financial markets—and much more!

Improve the conduct of monetary policyChina will continue to implement the sound monetary policy and improve

monetary policy mechanism mainly based on indirect instruments. Open mar-

ket operations will be expanded, with better decisionmaking. While enlarging

the trading volume of repurchases, it will enhance operations in the outright

spot market for government bonds. Trading methods will be chosen flexibly,

and open market operations will be given further play in directing and adjust-

ing short-term market rates. Primary dealers will be encouraged to do more in

increasing market liquidity and transmitting monetary policy intentions. The

0.0

0.3

0.6

0.9

1.2

1.5

1999 1995 1990 1985 1981

Ratio of M2 to GDP (percent)

Figure 3. Financial deepening in China, 1981–99

CHINA

75

infrastructure of open market operations will be strengthened and the pay-

ment system improved.

Market-based interest rate reform will be gradually advanced and an inter-

est rate system established, with the central bank rate as the benchmark and

deposit and lending rates of financial institutions determined by the market.

The interest rate reform will follow the sequence of foreign currency before

domestic currency, rural financial institutions before urban financial institu-

tions and lending rates before deposit rates.

The detailed plan is as follows. Interest rates of domestic corporate

bonds will be fully decided by the market. Deposit and lending rates charged

by rural credit cooperatives will be based purely on supply and demand of

funds in the rural areas and the risk of lending. The floating band for the

lending rate of urban financial institutions will be further expanded while

control of general deposit rate continues and large-value deposit rates are

managed flexibly.

Implement comprehensive reform of state-owned commercial banksThe general objective of reform and development of the wholly state-owned

commercial banks is to deepen institutional reforms, enhance the ownership

structure and improve corporate governance, operational mechanisms, per-

sonnel and incentive systems. The goal is to bring the share of nonperform-

ing loans below 15 percent and keep the capital adequacy ratio above 8 percent,

while maintaining profit growth.

The reform priority is to establish a modern banking system around 2005

through equity restructuring of the banking sector, especially the big four

wholly state-owned commercial banks. The main reforms:

• Introduce ownership and equity reform. Commercial banks will be

operated truly on market principles. An efficient internal corporate

governance system will be established. Some of the state-owned com-

mercial banks that meet certain criteria will be restructured into

joint-equity banks with the state holding the controlling stake, to

pave the way for these banks to go public later.

• Streamline branch networks following the principles of retrenchment,

efficiency and profitability. Internal organizations will be set up

according to the rational division of labor and mutual restraint.

• Introduce a prudential accounting system, and gradually resolve the his-

torical burden to improve asset quality. Accounting standards will be

modified, the system of establishing provisions and writing off bad


76

loans reformed, the business tax on commercial banks reduced and

five-category loan classification system applied more extensively.

• Increase capital adequacy through various channels while introducing

and perfecting the capital replenishment mechanism of commercial

banks.

• Improve external supervision of commercial banks and take two steps

to strengthen transparency of state-owned commercial banks so that

information disclosure of China’s banking industry meets interna-

tional standards. First, revise the banking industry’s accounting sys-

tem to encourage commercial banks to disclose information on

nonperforming loans and increase the frequency of disclosure.

Second, disclose more information on the performance and finan-

cial situation of commercial banks to meet international standards.

Commercial banks will also be encouraged to develop new business prod-

ucts and improve their incentive schemes.

Deepen the reform of rural credit cooperatives and improve financialservices in rural areasThe reform of rural credit cooperatives should clarify ownership, strengthen

disciplinary mechanism, reinforce functions in financial services, seek appro-

priate government support and hold local governments accountable. In line

with these principles, rural credit cooperatives will be transformed into local

community financial institutions where farmers, rural businesses and other

various economic entities jointly hold the stock, thus becoming financial insti-

tutions specializing in providing services to farmers, agriculture and the rural

economy. Internal controls and operational mechanisms will be strengthened

to prevent and mitigate financial risks. The rural credit cooperatives should

also act as the main financial force to support economic structural adjust-

ment in rural areas, help farmers increase their incomes and promote the bal-

anced development of urban and rural economy.

Speed the development of financial marketsFinancial markets are an important transmission channel for monetary pol-

icy, and their development has impacts on the efficiency of the financial sec-

tor and effectiveness of monetary policy. China needs to accelerate the

development of the financial markets in three ways.

First, a unified money market will be established with different levels,

open to all financial institutions.

CHINA

77

Second, the development of China’s capital market will be advanced,

strengthening corporate governance, improving market institutions and

upgrading supervisory skills. To protect investors, the operations of listed com-

panies and security firms will be regulated to increase information disclosure.

Third, interactions between money markets and capital markets will be

established to prevent financial risks and deepen and broaden the impact of

monetary policy on the economy.

Improve the managed floating exchange rate regime of the yuanThe current exchange rate regime needs further improvement, based on the

stability of the reminbi (RMB). China will gradually enhance the role of the

market in the formation of exchange rate. It will also improve the policy for

managing the foreign exchange position of banks resulting from purchase

and sale of foreign exchange and the arrangement of compulsory sale of for-

eign exchange.

The following measures will further develop the foreign exchange market:

• Introducing forward contracts for the purchase and sale of foreign

exchanges.

• Extending the business hours of the interbank foreign exchange markets.

• Diversifying trading products in the foreign exchange market.

• Improving the intervention by the central bank.

• Modifying the management goal of the exchange rate.

• Strengthening the surveillance and early-warning mechanism of the

foreign exchange market.

Gradually remove capital account controlsChina will gradually create the prudential conditions for capital account lib-

eralization by:

• Gradually applying market interest rates, tax rates and exchange rates

to manage the domestic economy to achieve overall macroeconomic

balance.

• Strengthening the capability of domestic enterprises and financial

institutions and improve their efficiency in the earning, use and

repayment of foreign exchange.

• Improving the government’s fiscal position.

• Keeping prices stable.

• Regulating the development of financial markets, especially the secu-

rities market.


78

• Improving financial supervision to prevent shocks form the flow of

international capital.

Open the financial markets even moreChina’s commitment to opening financial markets under the WTO’s frame-

work will be strictly honored. Within five years from WTO accession, the

number of cities where foreign banks are allowed to operate RMB business

will be gradually increased. And foreign banks will be permitted to do RMB

business without any geographical restrictions, enjoying complete national

treatment.

Strengthen financial supervision to assure national economic and financialsecurityA country’s economic and financial security depends largely on the soundness

of banking supervision that meets international standards. The set-up of

China Banking Regulatory Commission will help enhance independence and

professionalism of the supervisory authority and intensify its capability in

deterring moral hazard and identifying and resolving financial risks.

China will also reform the accounting system, strengthen self-discipline

in the financial industry and encourage law firms, accounting firms and rat-

ing agencies to do more in supervising financial institutions. More impor-

tant, the central bank will monitor the interaction of money markets, capital

markets and insurance markets from a macro perspective, to prevent finan-

cial risks and maintain financial stability.

To sum up, China will strive to establish a sound and highly efficient

financial system, possibly in a short time frame, to maintain macroeconomic

stability and promote economic growth.

CHINA

79

FRANCEIn 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.

THE FIRST STEPS TOWARD LIBERALIZATION BEFORE 1984The crisis faced by the banking sector in the 1930s has led French authorities

to reinforce the institutional framework. The Act of 13 June 1941, as amended

in 1945, created a control institution—the Conseil national du crédit. This

act also distinguished between deposit banks, investment banks, medium-

and long-term credit banks and financial institutions. All these entities are

now classified as commercial banks, after being known as “AFB banks” (banks

belonging to the French Bankers’ Association—AFB).

The old classification restricted the role of each category of bank. The

compartmentalization of business activities was based on the time horizon of

transactions. For example, deposit banks were allowed to engage only in short-

term transactions, credit banks in medium- and long-term transactions. The

purpose was to control lending and to regulate the creation of money and the

allocation of savings.

The nationalization of the Banque de France and the four leading deposit

banks (Crédit Lyonnais, Société Générale, Banque Nationale pour le Com-

merce et l’Industrie and Comptoir d’Escompte de Paris) after the war gave the

government a predominant role in France’s banking industry. The Act of 11

February 1982, which nationalized 36 deposit banks, further increased the

influence of the government, leaving almost all banks owned by the state. The

government’s purpose was to control financial flows in France and to ensure

the support from a key economic sector for the country’s growth.

The banking business was thus severely constrained as a result of lending

restrictions, regulated savings schemes and restrictions on the types of busi-

ness that each category of bank was allowed to engage in. These constraints

80

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.

THE BANKING ACT OF 1984 GAVE THE REAL IMPETUS TO FRENCH

BANKING LIBERALIZATION

The 1984 Banking Act created a single legal framework for all financial enti-

ties, now called “credit institutions”. The first article of the Banking Act states

that “credit institutions are legal persons carrying out banking operations as

their regular business”. Credit institutions were also allowed to carry out some

other operations related to their business. The main goal of the new law was to

create the conditions for fair competition and to spur the modernization of

banks. In that respect, the French Banking Act is based on universalism, but the

diversity of the French banks’ status did not allow a complete universality.

Different types of credit institutions are defined in article 18:

• Banks may carry out all banking operations. Mutual or cooperative

banks, savings and provident institutions and municipal credit banks

may carry out all banking operations subject to the restrictions aris-

ing under the laws and regulations governing them.

• Financial companies are subject to restrictions on the range of instru-

ments they can provide to their customers (for instance, they are not

FRANCE

81


82

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,

BOX 1

THE BANKING ACT SUBMITTED ALL CREDIT INSTITUTIONS TOTHE SAME AUTHORITIES

The Conseil national du crédit et du titre studies the working of thebanking and financial system, particularly as regards customers rela-tions and the administrating of means of payment. It may issue opin-ions in these areas.

The Comité de la réglementation bancaire et financière has verybroad statutory powers to lay down general regulations applicable toall credit institutions. It is entitled to define capital requirements,conditions relating to banking operations, operational standards thatinstitutions must adhere to, prudential ratios, reserve requirementsand so on.

The Comité des établissements de crédit et des entreprises d’in-vestissement is responsible for granting individual licenses and autho-rizations to credit institutions and investment firms.

The Commission bancaire is responsible for the supervision ofcredit institutions. It has powers to take disciplinary action againstany breach of the Banking Act and the regulations laid down by theComité de la réglementation bancaire et financière. It examines theoperations of credit institutions and monitors the soundness of theirfinancial condition through periodic returns filed by credit institu-tions and via on-site supervision.

the Institut d’emission d’Outre–Mer, the Caisse des dépôts et consignations

and the financial services of the Post Office can carry out banking operations

without being considered as credit institutions. Furthermore, some credit

institutions still have particularisms such as the livret A commercialized by the

Caisses d’Épargne and the livret bleu of Credit Mutuel.

The regulatory environment continued to change after the act was imple-

mented, but the trend was always towards greater harmonization. The 1999

Savings and Financial Security Act validated the new bylaws for savings and

provident institutions (Caisses d’Épargne), which became mutual banks. It

also instituted a single deposit insurance fund covering all French credit insti-

tutions. As a result, the French banking industry has become more uniform,

even though some institutions still maintain some specific features, such as the

regulated passbook savings accounts offered by savings and provident insti-

tutions and Crédit Mutuel.

THE BANKING ACT PAVED THE WAY FOR A STRONGER BANKING

SYSTEM

The French banking system did not avoid an adjustment crisis in the shift

from a very regulated and stable system to a liberalized, challenging and open

system. The increased competition among banks eroded interest margins and

spurred risks linked to the quest for new markets in a context of lower mar-

ket rates. The gradual liberalization of financial markets that started in the

mid-1980s increased competition from nonbanks, such as mutual funds and

insurance companies, but even more, it stimulated competition in markets.

Economic agents were given the right to issue money market instruments

in 1985 and 1986, opening up new possibilities for market financing. And the

national law of the European Directive of 24 June 1988 on the free movement

of capital eliminated lending restrictions and currency controls, removing

many of administrative barriers that compartmentalized the business of credit

institutions in European countries.

This had a particularly large impact on traditional banking intermedia-

tion business, which gave way to disintermediation in lending and an align-

ment of bank lending rates and financial markets rates. The financial

intermediation ratio—the proportion of total lending to nonfinancial agents

obtained from resident financial intermediaries—fell from 71 percent in 1978

to less than 41 percent in 2001. More recently, the stock market slowdown has

partially counterbalanced this trend, and some corporations returned to tra-

ditional bank financing.

FRANCE

83

To preserve their income, credit institutions have largely participated in

the disintermediation process and in the growth of market operations. Retail

business provides 50 percent of net banking income, corporate banking 33

percent and asset management 10 percent. The share of commissions in the

net banking income has steadily increased since the beginning of the 1990s to

reach 45 percent on average.

For the past decade, the application of rules related to the European cap-

ital ratio and to internal control has led French banks to pay more attention to

cutting costs and managing risks. The operating cost reductions brought lim-

ited staff reductions and a reallocation toward commercial tasks. Information

technology investments have been important, particularly for standardization.

And credit institutions have reinforced their risk management systems, improv-

ing geographical and sectoral analysis of credit and market risks, which have

led to better provisioning practices.

Since the mid-1990s the capital solvency ratios of French banks have risen

steadily. At the end of 2003, the book value of their capital reached €213.4 bil-

lion, or 5.4 percent of their balance sheet, up from 3 percent in the mid 1980s.

DEREGULATION ALLOWED GREATER CONCENTRATION AND THE RISE

OF POWERFUL BANKING GROUPS

Until the beginning of the 1980s, the number of credit institutions grew, as

many foreign banks arrived on the French market and new institutions were

created to specialize in specific lines of business and types of financing. But

then the number of banks fell. The number of credit institutions in France

(excluding Monaco) and authorized by the Comité des établissements de

crédit et des entreprises d’investissement shrank from 2,001 in 1984 and 2,027

in 1990 to 925 in 2003 (figure 1).

The shrinking population of banks has resulted from the closing of insti-

tutions that had no prospects for expansion in a more competitive environ-

ment and from mergers of institutions with similar characteristics. A wave of

reorganizations and renovations of banking structures also reduced the num-

ber of institutions. The leading institutions have steadily grown bigger in

recent years, but this has not harmed the interests of economic agents, who

still have the same number of branches available. The share of total banking

assets held by the top 20 institutions rose from 65 percent in 1988 to 80 per-

cent in 2003, on the basis of parent company balance sheets. On the basis of

consolidated balance sheets, which record the assets of subsidiaries as well,

the top five banking groups in France account for more than 71 percent of


84

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.

State ownership and family ownership have nearly disappearedAfter several waves of privatization in 1986, 1987, 1993 and finally at the end

of the 1990s, most state-owned credit institutions had either been listed on the

stock market or bought by other banks. And the number of family-owned

banks dwindled. There were only 7 such banks in 2001, down from 34 in 1984.

This leaves most small, family-owned banks without the resources to sustain

their business and achieve sound growth.

Restructuring has affected all types of banking institutionsThe market share of large groups has increased along with the role of mutual

and cooperative groups. In addition to organic growth, mutual and coopera-

tive banks have played an active part in restructuring the French banking

industry. The Crédit Mutuel group bought the Crédit Industriel et

Commercial group when it was privatized in 1998. Other examples include

FRANCE

85

0

500

1,000

1,500

2,000

2,500

2003200019981996199419921990198819861984

Figure 1. Credit institutions and investment firms, 1984–2003 (excluding Monaco)

Credit institutions

Investment firms

Source: DECEI.

Banques Populaires’ successive acquisitions of equity stakes in Banque

française de commerce extérieur (completed in 1998 to create Natexis) and the

Caisses d’Épargne network’s stake in Crédit Foncier de France and more

recently the acquisition of Caisse des Dépôts et Consignations’ competitive

businesses. The Crédit Agricole group took over Indosuez in 1996, Sofinco in

1998, Finaref and Crédit Lyonnais in 2003. This last takeover marks a major

change in France’s banking industry and confirms the mutual group’s leading

share of the retail banking business in France.

Other bank mergers and takeovers include Société Générale’s acquisition

of Crédit du Nord in 1997, CCF’s acquisition of Société Marseillaise de Crédit

in 1998 and BNP’s takeover of Paribas in 1999. Among foreign groups, the only

important operations have been the takeover of CCF by HSBC and the cre-

ation of Dexia from Crédit Local de France and Crédit Communal de

Belgique. Seven groups now dominate France’s banking system: BNP-Paribas,

Crédit Agricole-Crédit Lyonnais, Société Générale, CCF-HSBC, Banques

Populaires, Caisses d’Épargne, Crédit Mutuel-Crédit Industriel et Commercial.

BNP-Paribas has become the fifth largest European bank in market cap-

italization and the first in the Euro area (figure 2). This accession of French

banks to the top ranks of international banks is a recent development. The tra-

ditional ownership structure of credit institutions did not lead to the emer-

gence of very large market capitalizations. Nor was the Paris financial center

large enough to facilitate French issuers’ accession to the top ranks. French

credit institutions were long hampered by an image problem stemming from

low operating profits. This situation has improved recently, as the leading

credit institutions have restructured and increased their operating profitabil-

ity, putting them on par with their EU competitors, particularly in the last

few years.

THE REGULATORY FRAMEWORK AND THE ACTIONS OF SUPERVISORY

AUTHORITIES HAVE STRENGTHENED THE BANKING SECTOR

The greater uniformity of business conditions for French banking also stems

from the efforts of international and European bodies to introduce regulatory

standards. The Basel Committee’s work has led to adaptations of European

and domestic regulations. In the late 1980s, regulations were tightened with

the insertion of the European Capital Adequacy Directive into French law,

setting the minimum ratio of regulatory capital to credit-risk-weighted assets

at 8 percent. In 1996 an additional capital requirement was introduced to

cover market risks. The European Directive on deposit guarantee schemes


86

enhanced protection for depositors and led to unification of the various

deposit guarantee schemes in the French banking system in 1999.

Another directive adopted in French laws and regulations is that for invest-

ment services, resulting in the 1996 Financial Activity Modernization Act. The

act provides for a single institutional framework for all types of investment ser-

vice providers in France. To take up this business, providers must obtain the

authorization of either the Comité des établissements de crédit et des entre-

prises d’investissement or France’s securities regulator, the Autorité des marchés

financiers, the former Commission des opérations de bourse, for portfolio

management firms.

FRANCE

0 30 60 90 120 150

Bankiter Capitalia

Monte Pashi Commerzbank AG

SE Banken AB Banco Popular Español

HypoVereinsbank Allied Irish Banks

San Paolo IMI KBC Bank Holding

Dexia CC Standard Charter Nordea Bank AB

Banca Intesa SpA Fortis NV

Unicredito SPA ABN AMRO Hold

Credit Suisse Group Crédit Agricole Deutsche Bank

Société Générale Lloyds TSB

BBVA BSCH HBOS

ING Groep NV BNP Paribas

Barclays UBS AG

Royal Bank of Scotland HSBC

Figure 2. Market capitalization of leading European banks, August 2004

Billions of euros

Source: Reuters.

87

The act also introduced a new category of financial institutions called

investment firms. On 1 January 1998 the former category of securities houses

was abolished and firms in that category fell into the new one. These compa-

nies are subject to the prudential supervision of the Commission bancaire,

except for portfolio management companies, which are supervised by the

Autorité des marchés financiers. The new category covers a wide variety of

business lines and corporate cultures, and the companies in it vary in size and

ownership structure.

These changes can be linked to the productivity gains by the leading banks

since the 1990s. But those gains are also the result of strong support from pru-

dential authorities, essentially after the Comité de la réglementation bancaire

et financière adopted Regulation 97-02 relating to internal control. This

highly innovative regulation—which the Basel Committee cited in its best-

practice recommendations for internal control—spurred credit institutions to

develop effective structures for recording, monitoring and managing risks.

The regulation outlines the minimum requirements for sound manage-

ment, the responsibilities of directors and the main organizational principles

for internal control. It also defines the function of an internal auditor and

insists on the need to analyze the geographical and sectoral aspects of credit

and market risks, along with their segmentation, management and even their

profitability (Article 20). It has had a noticeable impact on the way credit insti-

tutions are structured, disseminating a control culture, critical with the expan-

sion of trading activities and the lack of transparency in some transactions.

Transparency, productivity and efficiency have been improved substantially.

SEPARATE SUPERVISORS—WITH GREATER CO OPERATION

France has opted for separate specialized supervisors for the banking sector,

the insurance sector and the financial markets. This specialization is set, how-

ever, within a framework of greater cooperation among supervisors. The

Commission bancaire and the insurance supervisor, Commission de contrôle

des assurances, formalized their efforts to enhance cooperation by signing a

memorandum of understanding on their cooperation framework on 24 October

2001. The charter defines practical cooperation procedures between the two

supervisors to facilitate the performance of their respective statutory duties.

The Commission bancaire, the Commission de contrôle des assurances

and the Commission des opérations de bourse meet several times a year to

exchange information and coordinate their action. For instance, the

Commission des opérations de bourse and the Commission bancaire published


88

FRANCE

89

joint recommendations on deconsolidation and derecognition of assets for

French institutions in a preventive move—to avoid problems with practices

allowable under foreign accounting rules.

The importance of this cooperation is apparent in the fight against money

laundering and terrorist financing. Authorities have been given wider powers

in this fight since 2001. The Commission bancaire is responsible for ensuring

that credit institutions comply with all of the measures for preventing and

detecting transactions laundering the proceeds of drug trafficking and orga-

nized crime. It ensures that procedures are in place to prevent criminal funds

from entering or circulating through the financial system.

For this task the Commission bancaire cooperates with national and inter-

national authorities. It is in contact with Tracfin, France’s financial intelli-

gence unit, customs, the Gendarmerie, law enforcement authorities and

administrative authorities. At the international level, it works with other super-

visors and international cooperation bodies such as the Basel Committee, the

Financial Action Task Force, the International Monetary Fund and the

Financial Stability Forum.

STRENGTHENING AND SIMPLIFYING

In August 2003 the loi de sécurité financière stated that the French banking

sector is ruled by common law and falls within the scope of the Conseil de la

concurrence, which consults the Comité des établissements de crédit et des

entreprises d’investissement when an operation is liable to affect banking sec-

tor competition. The adoption of the loi de sécurité financière has strength-

ened and simplified supervision of financial services in France. Financial

regulators have been reorganized according to the twin peaks: strict separa-

tion of market authorities in charge of exchanges, financial operations and the

protection of savings—and prudential authorities in charge of the supervisor

of the banking and insurance sectors.

A new market authority, the Autorité des marchés financiers, replaced the

Commission des operations de bourse, the Conseil des marchés financiers and

the Conseil de discipline de la gestion financière, which supervised the ethics of

portfolio management companies.

This new architecture simplified the regulatory system for exchanges. And

prudential regulation of the banking and insurance sectors has been reorga-

nized. For each of these sectors there are now three authorities: one in charge

of regulation (the Minister of Finance assisted by a consultative committee),

one in charge of granting individual licenses and authorizations to credit insti-

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.

ANNEX A FRENCH FINANCIAL LEGISLATION

• Banking Act 84-46 of 24 January 1984.

• Act 92-665 of 16 July 1992, as amended, adaptating insurance and

credit legislation to the Single European Market.

• Financial Activity Modernization Act 96-597 of 2 July 1996.

• Savings and Financial Security Act 99-532 of 25 June 1999.

• Order 2000-1223 of 14 December 2000 on the legislative part of the

Monetary and Financial Code.

• New Economic Regulation Act 2001-420 of 15 May 2001.

• Everyday Security Act 2001-1062 of 15 November 2001.

• Urgent Economic and Financial Measures Act 2001-1168 of 11

December 2001.

• Financial Security Act 2003-706 of 1 August 2003.


90

GERMANYGermany’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


92

Tabl

e 1

Vol

um

e an

d s

tru

ctu

re o

fth

e G

erm

an fi

nan

cial

sys

tem

,yea

r-en

d 2

003

(per

cen

t of

GD

P)

Fund

s in

vest

edFu

nds

rais

edDe

posi

ts, l

oans

, mut

ual

Shar

esDe

posi

ts, l

oans

, mut

ual

Shar

esfu

nds

and

othe

r cla

ims

and

othe

rfu

nds

and

othe

r lia

bilit

ies

and

othe

rSe

ctor

Tota

lBa

nks

secu

ritie

sTo

tal

Tota

lBa

nks

secu

ritie

sTo

tal

Resi

dent

non

finan

cial

sec

tors

174

9190

264

165

127

119

283

Hous

ehol

ds13

762

3917

772

69—

72Co

rpor

atio

ns26

1947

7370

3874

144

Gene

ral g

over

nmen

t10

94

1422

2045

67Re

side

nt fi

nanc

ial s

ecto

rs23

074

118

348

235

9797

332

Bank

s18

651

6525

114

689

9023

6In

sura

nce

com

pani

es40

2018

5850

17

56In

vest

men

t fun

ds4

435

3939

70

39N

onre

side

nts

6843

7414

363

5567

130

Tota

l47

220

828

375

546

227

828

374

5M

emo

item

:To

tal e

xclu

ding

resi

dent

fin

anci

al s

ecto

rs24

216

516

440

722

818

218

641

3

— N

ot a

pplic

able

.No

te: F

igur

es m

ay n

ot s

um to

tota

ls b

ecau

se o

f rou

ndin

g.So

urce

: Deu

tsch

e Bu

ndes

bank

.

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.

GERMANY’S MACROECONOMIC AND LEGAL FRAMEWORK

The important role that small and medium-size enterprises have traditionally

played in the German economy partly explains the bank-based character of the

country’s financial system. However, the significance of small and medium-

size enterprises has diminished somewhat in recent years. In response to the

increasing challenges posed by globalization, many small and medium-size

enterprises have merged to create larger, more competitive companies.

Germany is very open to imports and exports. For a large country, its

economy has a very closely knit web of international trade links. This feature

emerged immediately after World War II, driven by the comprehensive and

quick deregulation and liberalization of the economy. The German “economic

miracle” owed much to the successful track record of exports. In that respect,

Germany’s development may be regarded as an example of export-led eco-

nomic growth. Early deregulation of the financial sector (regulation of capi-

tal market rates was dropped in 1952) helped liberalize international capital

movements early on (capital account convertibility was achieved in 1958),

enhancing the international integration of the German economy and increas-

ing Germany’s competitiveness.

GERMANY

93

Economic governanceEconomic 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 stabilityEconomic 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

establishment of the Federal Republic of Germany—was independent de facto.

The Bundesbank Act formally articulated the independence of the

Bundesbank, which does not take instructions from the federal government.

The central bank and the federal governments have always broadly agreed

on the beneficial effects of price stability, although there have been occasional

conflicts, usually reflecting different time horizons of policymakers. In the

mid-1950s, for instance, the federal government pressured the Bank deutscher

Länder to refrain from tightening its monetary policy in order to help

improve the cyclical situation. The bank believed that maintaining lower

interest rates would jeopardize price stability and therefore increased its lend-

ing rates. Annoyed by this move, Chancellor Konrad Adenauer gave a famous

speech in which he publicly declared that the central bank’s monetary policy

was the “guillotine” of the economy. Because of its good track record of mon-

etary stability, its effective independence and, above all, the stability culture

that was prevalent among the German people, the bank grew in strength as

a result of this episode. The conflict paved the way for the Bundesbank’s statu-

tory independence and a sustained monetary policy geared toward main-

taining price stability. As a result of the solid track record of German

monetary policy, the Bundesbank’s commitment to price stability and its

independence became the model for institution building in monetary policy

in Europe.

Recognizing that monetary policy can be successful in the longer run only

if it is bolstered by prudent fiscal policy, the German constitution stipulated

from its inception that borrowing by the federal government must not exceed

its total investment expenditures. Similar provisions exist in the Land (or state)

constitutions. In practice, these “golden rules” did not represent hard budget

constraints, as public investment was always defined broadly. Moreover, at the

end of the 1960s the German constitution was amended to allow federal

borrowing to exceed federal investment expenditures if necessary to avert a

disturbance of the overall economic equilibrium (without defining “distur-

bance”). Since the creation of the European Monetary Union, these provi-

sions have been overridden by the more stringent principles, rules and

procedures of the European Stability and Growth Pact, whose practical impact

on strengthening fiscal discipline has remained below initial expectations,

however. In order to reduce the potential for conflicts, the Bundesbank has

successfully advised all federal governments to keep the volume of short-term

or floating-rate debt at low levels, thus ensuring greater independence of pub-

lic finances from monetary policy measures.

GERMANY

95

Legislation on collateral and insolvencyLegal certainty is an important precondition for the proper functioning of a

market economy. Creating such certainty requires legal concepts and instru-

ments that are closely geared to the practical needs of economic agents, as

well as effective procedures for enforcing these instruments. Collateral and

insolvency legislation is key to containing credit risk (and thereby reducing the

cost of capital).

Collateral can be provided in various ways under the German Civil Code,

each catering to different economic needs. The law deals with movable goods

(such as machinery or securities), debtor rights (such as financial claims

against third parties) and real estate.

Two main methods are available for using movable goods or debtor rights

as collateral: the classic pledge and the transfer of ownership. In addition, spe-

cial procedures apply for providing collateral by encumbering real estate.

Under a classic pledge, the asset is transferred to the creditor, while the

ownership of the pledged asset remains with the collateral provider.3 The

pledge is an ideal instrument in situations in which the transfer of possession

of the collateral raises no practical problems, that is, where easily trans-

portable assets are involved (jewelry, small antiques); control is transferred

within custody systems (bullion, securities); or rights (such as company

shares) are used. The pledge is established informally; no written agreement

or other formalities are required. No court involvement is needed to enforce

the pledge: in the event of default, the collateral taker may sell the pledged

asset at market prices.4

Transfer of ownership does not require the collateral taker to take physi-

cal possession of the asset. It is an ideal instrument in cases in which the debtor

wants to use mobile equipment, such as machinery, goods and commodities,

as collateral. This method may also be used for receivables and other claims.

Transfer of ownership is thus a widely used instrument for securing loans to

finance the acquisition of capital goods or to secure supplier credits. The trans-

fer of ownership can be established informally, and enforcement requires nei-

ther court involvement nor any specific procedures (such as a public sale or

auction, as required in the case of a classic pledge), since the collateral taker

is already the owner.

Encumbrances of real estate are valid only if established by a notarized

deed and entered into the public land register. Therefore, the land register

always provides perfect and complete information about ownership and

encumbrances of real estate. As a result, real estate is widely used as collateral.


96

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.

PRINCIPLES OF BANKING SUPERVISION

Banking supervision incorporates a supervisory framework rooted in market-

based principles and in procedures for crisis management.

Structure of the German banking systemUniversal banks in Germany can be classified into three groups: commercial

banks, savings banks and cooperative banks. (In addition, there are a small

number of specialized institutions.) Commercial banks include international,

national and regional banks, foreign banks and private bankers. The main

common feature of this otherwise very heterogeneous group is their legal sta-

tus as private-law enterprises.

The much more numerous savings banks (including the Land banks,

which provide various operational facilities and services for retail-oriented

savings banks) are based on public law and owned by public authorities.

Owners and guarantors of savings banks are local authorities, while Land

banks are owned and supported by the Land governments. When the savings

banks emerged in the 19th century, they helped provide equal access to bank-

ing services and fostered broad-based asset formation. Following an agree-

ment with the European Commission, the savings bank system will lose its

public financial guarantees in 2005 in order to ensure a level playing field in

the German financial sector.

GERMANY

97

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 frameworkGerman 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

Table 2

Number of licensed banks in Germany, by type of institution,1972–2003

Year Commercial banksa Savings banks Cooperative banks Total

1972 314 788 5,756 6,8581982 244 607 3,827 4,6781992b 334 730 2,915 3,9792002 297 532 1,492 2,3212003 287 502 1,396 2,185

a. Excludes domestic investment banks as well as branches of foreign investment banks, which have beenincluded in official statistics only since 1992.b. Figures reflect the effect of German reunification.Source: Deutsche Bundesbank.

information. The key instrument of banking supervision is the credit institu-

tions’ obligation to meet stringent liquidity and solvency criteria at all times.

Legal basis for banking supervision. The legal basis for banking supervision

is the Banking Act, adopted in 1961 and last amended in 2002. The act designates

BaFin and the Bundesbank as the bodies responsible for supervising banks and

investment firms and established the organizational framework within which

they cooperate. The act regulates prudentially relevant matters, such as licensing,

ongoing monitoring, on-site inspections and crisis management (box 1).

GERMANY

99

BOX 1

SUPERVISORY ACTIVITIES STIPULATED BY THE BANKING ACT

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.

Revocation of the license• Are the conditions for granting the license no longer met?• Do losses amount to half the liable capital?• Have losses amounted to 10 percent of the liable capital during three

successive years?

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

BaFin is exclusively responsible for exercising all sovereign functions and

supervisory actions. It works closely with the Bundesbank in regulating and

supervising banks. The Bundesbank is involved in the day-to-day monitoring

of banks and investment firms. It must observe guidelines issued by BaFin

(and agreed upon by the Bundesbank) and the Ministry of Finance (in con-

sultation with the Bundesbank). As a rule, BaFin bases its regulatory measures

on the Bundesbank’s audit findings and appraisals, while reserving the right

to perform its own on-site audits in the limited number of cases in which its

final supervisory responsibility suggests the need for such audits. Overall, the

Bundesbank’s role in banking supervision has been strengthened, owing to an

improved division of labor between the two institutions.

Reporting and accounting requirements. Banks are required to report the

information needed to assess their liquidity and capital adequacy every month

to BaFin and the Bundesbank. In order to limit reporting demands, the

monthly balance sheet statistics collected for monetary policy analysis serve

as monthly returns for prudential purposes. To assess banks’ income, liquid-

ity and solvency, the Bundesbank and BaFin also use the banks’ annual

accounts and the statutory reports prepared by external auditors. (For details

on reporting requirements, see annex A.)

Supervisors have a vested interest in ensuring sound accounting rules.

Accounting practices in Germany have traditionally been defined by the pru-

dence principle. Its main elements are creditor protection, the principle of

valuation at amortized cost, the principle of lower of cost or market, the

imparity and realization principles and the principle of capital preservation.

These accounting methods prevent income from being reported before gains

have actually been realized or the risk of losses permanently averted. They are

consistent with the interests of the supervisor. From the perspective of bank-

ing supervision, undisclosed contingency reserves perform an important

buffer role for the financial system during periods of stress, thus enhancing

stability.

Beginning in 2005 publicly traded banking groups will be required to draw

up their consolidated accounts in accordance with International Accounting

Standards (IAS; in the future, International Financial Reporting Standards

[IFRS]). It is likely that IAS reporting will gain increasing importance for the

annual accounts of individual institutions, which are the main source of infor-

mation for German supervisors. Under IAS the increasing role of fair-value

accounting and the comprehensive valuation of uncompleted transactions

(derivatives) will imply considerable volatility risks for prudentially relevant

GERMANY

101

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

Crisis management frameworkPowers of BaFin. In cases of violation of regulatory provisions, BaFin can

deploy a series of increasingly severe measures (see box 1). It also has police

powers to combat unauthorized business. The Banking Act lists the remedial

measures that can be taken if an institution has inadequate liquidity or capi-

tal or if there is a concrete danger of insolvency. These measures range from

blocking the distribution of profits, the granting of loans and the acceptance

of deposits to excluding managers from business activities. As a last resort,

BaFin can revoke an institution’s license.

Deposit protection schemes. Deposit protection in Germany has long been

based on voluntary self-help facilities in favor of nonbanks, established sepa-

rately by the associations of the three categories of banks. All three groups of

banks have their own audit associations, which try to identify risks at an early

stage. Additional statutory regulations have existed in Germany only since 1998,

following the implementation of an EU directive. EU legislation dictates that

all private- and public-law institutions that accept deposits must belong to a

statutory deposit-protection scheme. The directive limits the statutory claim to

compensation to deposits denominated in euros or other currencies used in the


102

European Economic Area and to a maximum of 90 percent of deposits per

creditor, up to a ceiling of €20,000.

Members of voluntary deposit schemes that safeguard the viability of the

institution—including all German savings banks and cooperatives—are

exempt from this rule. Savings bank and cooperative bank sectors provide full

protection for deposits, since their strategies aim at preventing default of the

institutions. Both the statutory scheme and the schemes safeguarding the via-

bility of institutions are subject to supervision by BaFin.

The private-law compensation fund established for commercial banks

protects nonsecuritized liabilities to nonbank creditors of up to 30 percent of

the liable capital of the defaulted bank as shown in its most recently published

annual accounts. By supplementing statutory protection, the voluntary pro-

tection scheme ensures more generous compensation for depositors. For com-

petitive reasons, nearly all commercial banks accepting deposits have joined

the voluntary protection scheme of their association.

In all the schemes, there are obligations to pay up further capital if the

fund’s assets fall below a minimum level. As a result, nonbank deposits in

Germany are protected virtually in full. Under these conditions, the risk of

moral hazard on the part of institutions—a phenomenon that has not been

observed in Germany—calls for particularly efficient supervisory procedures,

including vigilance on the part of bank audit associations.

Liquidity assistance for banks in distress. The Bundesbank pursues a cau-

tious policy with regard to granting financial assistance to banks that, despite

strict supervisory liquidity requirements, experience a liquidity crisis. In order

to avoid the moral hazard that could arise from a guarantee of liquidity sup-

port for distressed institutions, the Bundesbank has not committed itself to

being a lender of last resort. Direct involvement by the Bundesbank in address-

ing a financial crisis is decided only on an ad hoc basis, reflecting a policy of

“constructive ambiguity”.7 The Bundesbank encourages banks to identify and

deal with financial crises “upstream” of the central bank.

In an effort to supplement the banks’ own crisis management frameworks,

in 1974 the Bundesbank and representatives of all categories of banks jointly

established the Liquidity Consortium Bank, which can grant liquidity assis-

tance to financially sound institutions against good collateral. This facility

includes a limited drawing line on the Bundesbank and could provide further

limited liquidity support, which would be shared by the Bundesbank at a ratio

of 30 percent. To date the Liquidity Consortium Bank has been called on only

in a few minor crises.

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NEW MEASURES FOR SAFEGUARDING CLIENTS OF LIFE INSURERS

At the end of 2003, following a period of strong growth in insurance business,

total funds invested by resident nonfinancial sectors and nonresidents with

German insurers amounted to 48 percent of GDP, 91 percent of which was

held by households. This compares with investments in the banking sector of

134 percent of GDP, 46 percent of which were held by households (see table

1). The significant amount of household investment with German insurers

mainly reflects the important role of life insurance policies. A recently

launched initiative by the government to supplement the statutory pay-as-

you-go pension scheme with funded elements is likely to give an additional

boost to the insurance industry.

The German insurance sector is very fragmented. This is particularly the

case for life insurance. There are a few important institutions whose sound-

ness is vital not only to their large number of policyholders but also to the sta-

bility of the German financial system. Five of the ten largest reinsurance

companies in the world are licensed in Germany.

Insurance supervision in Germany is governed by the Insurance Super-

vision Law of 1901 and the Law Concerning the Insurance Contract of 1908.

Legislation has been guided by the twin objectives of safeguarding the inter-

ests of the policyholder and enabling insurers to meet their liabilities under

the insurance contracts at any time. Much emphasis is given to principles

determining market access and contractual terms. Rules regarding the distri-

bution of investments also play an important role. For example, no more than

35 percent of the insurers’“restricted assets” may be invested in shares or other

equity instruments, and investments in debt products have to comply with rat-

ing requirements.

In 2002 the downturn in stock markets began to bite deeply into insur-

ance companies’ profits and reserves. In response, BaFin agreed to a loss-

smoothing application of the obligatory lower-of-cost-or-market accounting

rules. This provided BaFin an opportunity to press for the creation of a pri-

vate rescue fund for averting losses to holders of life insurance policies. In

December 2002 such a scheme (Protector) was established on a voluntary

basis. Moreover, the private health insurers established a similar rescue fund

(Medicator) in July 2003. Protector went into action for the first time in mid-

2003, when it took over the insurance portfolio of a medium-size life insurer

that could not meet supervisory capital requirements as a result of stock mar-

ket losses. However, experience with Protector’s first intervention has shown

that the effectiveness of voluntary cooperation appears to be more difficult


104

than anticipated. Therefore, the federal government has proposed to introduce

limited obligatory rescue funds for life and health insurers. Under the pro-

posed legislation, all health and life insurers will be obliged to contribute to the

guarantee pools according to their market share and risk exposure. Companies

that have incurred higher risks will be required to make higher contributions.

While life insurers will have to pre-finance their rescue fund, health insurers will

be required to contribute only in the event of a crisis. Policyholders will have

to pay higher premiums for this safety net. Also, in the event of a default life

insurances may face a cut in benefits of up to 5 percent of the amount insured

if the fund’s capital is not sufficient to cover all contract claims.

The ongoing European harmonization of supervisory rules for financial

services will probably further strengthen prudential requirements for the

German insurance sector in the medium term. In the future the industry’s

minimum capital requirements are likely to be based more on a risk-oriented

approach, which encourages companies to carefully gauge and monitor their

exposures. Supervision of reinsurers in Germany is currently limited largely

to auditing their accounts. It is therefore welcome that various international

initiatives have been launched with the aim of strengthening the prudential

regime for reinsurance companies.

CAPITAL MARKET REFORMS IN THE WAKE OF GLOBALIZATION

In contrast to the approach adopted for the real economy, the new postwar

capital market was initially strictly regulated, with the objective of channelling

scarce resources primarily into housing construction and infrastructure invest-

ment. Pfandbrief securities (box 2), issued by banks and collateralized by

claims on real estate or the public sector, played an important role in the revival

of the bond market in Germany. Until the end of the 1980s, banks remained

far and away the most important issuers on the bond market. Following high

and persistent budget deficits, the public sector took over this position, with

federal government bonds providing benchmarks for European long-term

interest rates. For a long time, banks were also the major players on the buyers’

side of the bond market, as households had a strong preference for saving

deposits. Only in the 1970s did bond yields began to outpace interest rates on

saving deposits, which led to a rapid broadening of the investor base. Despite

efforts by successive federal governments to popularize shareholding—

through the partial privatization of state-owned companies and the sale of

their shares at low prices, for example—the equity market remained stunted

until the early 1980s.

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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

BOX 2

THE PFANDBRIEF: GERMANY’S COVERED BOND

Covered bonds can be an important instrument for promoting secu-rities markets. This type of instrument has a long tradition inGermany, in the form of the Pfandbrief, which dates as far back as1769. The original purpose of the Pfandbrief was to give large Prussianlandowners access to cheap credit by allowing private regional enti-ties to issue securities collateralized by the real estate of their bor-rowers (mortgage loans).

Whereas other kinds of mortgage-backed securities may be issuedby special-purpose entities, only credit institutions meeting demand-ing criteria are eligible to issue Pfandbrief securities. The major issuersare private mortgage banks and public-law credit institutions. Theirlending business is confined mostly to housing loans secured by mort-gages and loans to the government. Two special mortgage banks grantlong-term shipping loans against shipping mortgages and issue shipmortgage bonds.

Pfandbrief issuers are subject not only to general prudentialsupervision but also to special legislation. The Mortgage Bank Actsubjects private issuers to strict investor protection terms in order toguarantee the quality of the Pfandbrief. Collateral is permitted in theform of mortgages or land charges, with land charges widely preferred


106

have been taken to strengthen market integrity, market transparency and

investor protection. In the process, a Federal Securities Supervisory Office was

established in 1994 (it has since merged into BaFin).

The comprehensive overhaul of the regulatory framework for the German

capital market has contributed to a significant increase in the contribution of

equities to corporate finance. Stock market capitalization rose from 9 percent

of GDP in 1981 to 40 percent in 2003 (after peaking at 67 percent in 2000).

Bonds issued by nonfinancial corporations continue to play only a minor role,

however, partly because of discriminatory taxation rules. Under the current

trade earnings tax (levied by communities), half of the interest paid on “per-

manent debt” (debt with a maturity of more than one year) is included in the

assessment basis, whereas interest on short-term loans remains tax free. In

principle, this burden could be avoided by issuing longer-term bonds on for-

eign markets through foreign subsidiaries, which then forward the funds to

their parent companies as short-term loans. Corporate bonds currently account

for less than 3 percent of outstanding domestic debt issues, although they are

because of their greater flexibility. The issuance of Pfandbrief securi-ties by public-law credit institutions is regulated on the same investorprotection grounds by the Act Relating to Pfandbrief Securities andSimilar Instruments Issued by Public-Law Credit Institutions. At pre-sent, new legislation is being prepared that, in principle, will open theissuance of Pfandbrief securities to all interested banks. The reformwill include a number of safeguards in order to retain the high degreeof investor protection the Pfandbrief has always provided.

The Pfandbrief instrument has spread from Germany to manyother countries, particularly in Europe. Given the widespread use of thePfandbrief in Europe, the EU Investment Services Directive has setminimum standards. According to the present-value cover principle,capital and interest claims on Pfandbrief issuers must be secured bycapital redemptions and interest payments on mortgage loans andloans to government. If an issuer defaults, the cover pool must be usedprimarily to repay capital and interest of Pfandbrief holders.

Pfandbrief securities and similar products represent the largestsegment of the European bond market, with more than three-quar-ters of the market held by German issuers. Maturities range from 1 to10 years, with medium-term maturities of 5–7 years predominating.In the 1990s traditional small Pfandbrief issues began to be replacedby syndicated jumbo issues with a minimum volume of €500 million,deepening the liquidity of the secondary market.

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increasing as a result of improved market conditions brought about by the

European monetary union.

The competitiveness of the German capital market benefits greatly from

its very efficient infrastructure for the clearing, safe custody and settlement of

securities. This highly integrated network is efficient and safe, and its trans-

actions costs compare favorably with international standards. (For the struc-

ture of the system, see annex C.)

MAJOR FEATURES OF THE PAYMENT SYSTEM

In discharging its mandate for the execution of domestic and international

payments, the Bundesbank acts as a provider of primary liquidity and of pay-

ment services and as an overseer, relying largely on the banking industry to

implement payment system standards and technologies.

The role of the BundesbankThe Bundesbank Act of 1957 mandated that the central bank arrange for the

execution of domestic and international payments. The most recent amend-

ment to the act, which went into effect in May 2002, confirmed the Bundes-

bank’s traditional responsibilities in this field and explicitly mandated that

the central bank contribute to the stability of the payment system.

European legislation also calls for the involvement of central banks. The

provisions of the treaty establishing the European Community as well as the

joint Statute of the European System of Central Banks and of the European

Central Bank stipulate that the European Central Bank and the national cen-

tral banks must promote the smooth operation of payment systems. The

statute allows the Eurosystem (comprising the European Central Bank and the

national central banks within the euro area) to provide facilities for this pur-

pose and to issue regulations to ensure efficient and sound payment systems

within the euro area and with other countries.

In discharging its mandate, the Bundesbank performs three major func-

tions in the German payment system. It acts as a provider of primary liquid-

ity, as a provider of payment services and as an overseer.

Providing primary liquidity. In the Eurosystem minimum reserve require-

ments are an important monetary policy instrument for managing the inter-

bank money market (this was also the case in Germany when the Bundesbank

conducted its monetary policy independently).8 At the same time, the

Bundesbank and the Eurosystem as a whole use minimum reserve require-

ments to provide primary liquidity to the payment system. The credit


108

institutions’ minimum reserves may be used as working balances to settle pay-

ments, as the reserve requirements have to be met only on a monthly average,

thus allowing payment-induced daily fluctuations in the balances. The fact

that the Eurosystem pays interest on minimum reserve balances is an advan-

tage for euro-area banks compared with credit institutions in countries where

the central bank does not remunerate any credit balances. The collateralized,

but unremunerated, intraday credit offered by the Bundesbank within the

framework of the Eurosystem improves the undisturbed flow of payments

throughout the day. Using primary liquidity, including collateralized intra-

day credit, for interbank settlements increases not only the efficiency but also

the overall security of the payment system.

Providing payment services. In Germany, as in many other countries, the

central bank provides a payment system for large-value (individual) inter-

bank transactions as the core of its activities in the payment field. Involvement

of the Bundesbank improves the implementation of monetary policy by facil-

itating the rapid distribution of liquidity in the market, and the official large-

value payment system helps contain systemic risks. The Bundesbank also

ensures access by smaller and larger institutions to interbank clearing.

The Real-Time Gross Settlement Plus (RTGSplus) system is the highly

advanced Bundesbank facility for executing large-value payments. It is also the

German access link to TARGET (Trans-European Automated Real-Time Gross

Settlement Express Transfer), the European central banks’ real-time gross set-

tlement network. RTGSplus is characterized by the following:

• The system was developed in close cooperation with the banking indus-

try. This has ensured that it is consistently geared to user requirements.

• All credit institutions or investment firms domiciled in the European

Economic Area may participate directly in the system.

• The security of a gross system with intraday finality of payments is

reinforced by liquidity-saving elements (for example, offsetting pay-

ments are drawn on as cover).

• Participants can control the use of their liquidity in accordance with

their own needs. It is possible to opt for one of various types of pay-

ment speed (express or limit payments) and execution times (“from”

and “up to” payments). Participants can modify the parameters at

any time up to final settlement.

• The processing of payments is very transparent. At all times partic-

ipants can access real-time information on the status in a payment

cycle.

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• As a result of the large volume of payments processed, RTGSplus is

very cost-effective, allowing fees to be relatively low while fully cov-

ering costs.

Germany’s central bank has provided clearing and settlement facilities

for small-value (retail) payments between banks for more than 100 years.

Through its branches, the Bundesbank’s predecessor was the only institution

that enabled financial institutions to channel cashless payments nationwide.

Today the Bundesbank’s retail payment system still plays a supporting and

complementary role, accounting for about 16 percent of all retail payments

transferred between banks. The Bundesbank finds it useful to remain involved

in managing interbank retail payments for several reasons. First, the central

bank can offset market imperfections in terms of access to an efficient, nation-

wide payment infrastructure. Second, market oversight of payments is facili-

tated by the central bank’s direct involvement. Third, the central bank can act

as a driving force in ensuring high-quality standards in interbank payments,

including the promotion of technological progress.

Oversight functions. In discharging its oversight functions, the Bundes-

bank does not confine itself to large-value and retail payment systems. It also

covers payment instruments (such as e-money), the cash leg of securities

transactions and the payment flows associated with correspondent banking

relationships. Resources are also devoted to monitoring and assessing devel-

opments in the field of cashless payments in order to evaluate potential risks.

The Bundesbank performs its oversight function through ongoing coopera-

tion with the banking industry as well as through close cooperation with

BaFin, where appropriate.

Commitments by the banking industry to promote cashless paymentsIn line with the underlying principles of economic governance in Germany,

the Bundesbank has always largely relied on initiatives of the banking indus-

try to implement satisfactory payment system standards and state-of-the-art

technologies. However, to prevent the inefficient segmentation of the pay-

ment system that would result from rival procedures and technologies, the

Bundesbank pursues a policy of enhancing payment efficiency by encourag-

ing the associations of the banking sector to proceed on the basis of volun-

tary intraindustry agreements. Attention is paid to ensure that voluntary

agreements do not restrict competition among the credit institutions with

regard to business conditions (such as business hours, transit times, prices

and credit entry terms).


110

The Central Credit Committee (founded in 1932 and re-established in

1953) is the banking sector’s most important forum for discussing current

banking issues within the industry and between the industry and the central

bank. Since 1959 its Working Group on Automation, which is chaired by the

Bundesbank, has been coordinating the discussion on enhancing safety and

efficiency in payments. The key considerations for adopting new technologies

have been that they operate reliably and are fully developed and tested, that

they permit future enhancement to a level consistent with the most up-to-date

procedures and that they are compatible with prevailing practices. As a result

of the group’s work, interbank payments became completely paperless in July

1997. (Annex D provides a chronology of the major steps taken to move

toward cashless payments.)

LESSONS AND RECOMMENDATIONS

Financial crises in other developed countries were often preceded by overex-

pansionary monetary policies, which fueled inflation, asset price bubbles or

both. Crises typically occurred when the monetary reins had to be tightened,

leaving the banking industry with huge volumes of nonperforming loans and

imposing substantial costs on the economy as a whole. These experiences sug-

gest that monetary prudence is an important prerequisite for stability and

efficiency in the financial sector. Introduction of de facto central bank inde-

pendence as early as 1948 proved a crucial innovation that institutionalized

the objective of price stability. On that basis, the credibility of monetary pol-

icy helped establish a stability culture in Germany, which has been beneficial

in fostering “long-termism” in national finance.

While monetary prudence is a precondition for stable and efficient finan-

cial markets, it cannot prevent financial crises; supervisory frameworks for

crisis prevention and crisis management are indispensable. In Germany the

powers of banking supervisors have never infringed on the banks’ sole respon-

sibility for their business. Instead, banking supervision has always relied on lay-

ing down general principles, such as liquidity ratios, and monitoring their

observance. Since its establishment the Bundesbank has been an integral part

of the banking supervision framework, taking due account of the central

bank’s interest in a stable banking system as its major transmission channel

for monetary policy. The establishment of BaFin in 2002 as an integrated

framework for supervising banks, insurance companies and securities markets

strengthened the role of the Bundesbank in banking supervision by enlarging

its responsibility for on-site inspections.

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To avoid moral hazard on the part of banks, the supervisory authorities

encourage them to identify and deal with financial crises themselves. To do so,

each of the three types of banks has its own voluntary deposit protection

scheme, which supplements an obligatory minimum compensation system

introduced in 1998 in accordance with EU legislation. In addition, the

Liquidity Consortium Bank was established by the Bundesbank and the bank-

ing system in 1974. If the bank is activated, the Bundesbank contributes a lim-

ited amount of liquidity support. Beyond that, the Bundesbank has never

assumed any commitments, leaving its potential lender-of-last-resort function

“constructively ambiguous”. In 2002 and 2003, at the initiative of BaFin, life

and health insurers also established private rescue funds in favor of policy-

holders.

Broad-based deregulation of the German capital market has taken place

over the past two decades. In addition to the European benchmark role of

Bunds (bolstered by the steep upswing of the German financial futures mar-

ket), the most remarkable feature of the German capital market remains the

predominant role of Pfandbrief securities. The success of the Pfandbrief reflects

Germany’s efficient and reliable collateral and insolvency legislation. This

instrument has been copied by many other countries, particularly in Europe.

It could be a promising device for developing strong domestic debt markets

in emerging economies as well.

Interbank payments are crucial to the stability and efficiency of the finan-

cial sector. The Bundesbank has always provided services to the banking indus-

try, mainly for executing large-value payments. This helps level the playing

field, increase reliability and efficiency and strengthen the Bundesbank’s exper-

tise in discharging its oversight function. In addition, the Bundesbank is pro-

moting cashless payments by encouraging intraindustry agreements on the

introduction of up-to-date standards and technologies, working closely with

banking sector associations.


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ANNEX AMAJOR REPORTING REQUIREMENTS IN BANKING SUPERVISION

Information required FrequencyLiquidity 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

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Netting agreements Quarterly

Netting in the case of swap, forward and

option transactions

Country risks Quarterly

Risk exposures

Risk provisions

Nonrealized reserves Annually

Difference between market and book value for real

estate, buildings and listed and unlisted securities

Large exposures Quarterly

Lending to individual borrowers reaching a certain

threshold in terms of liable capital

Lending to individual borrowers reaching €1.5 million

or more at any time in the reporting period

Participating interests Quarterly

Ownership shares and own-funds components

for affiliated enterprises

Note: Where applicable, reports have to be submitted for the individual institution and for the group asa whole.


114

ANNEX BCAPITAL MARKET REFORMS, 1985–2002Year Regulatory change1985 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.

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2000 Tax reform

• Capital gains from the sale of equity stakes exempted from

corporation tax, beginning January 2002.

2002 Securities Acquisition and Takeover Act

• Increased transparency for stakeholders regarding mergers and

acquisitions.

Creation of the Federal Financial Supervisory Authority (BaFin)

• Establishment of a single supervisory authority for all financial

services by merging the federal supervisory offices for banks,

insurance companies and securities markets.

Fourth Financial Market Promotion Act

• Elimination of the priority treatment given to floor trading and the

setting of prices by brokers in official trading.

• Introduction of rules for the supervision of over-the-counter

trading systems.

• Increased specificity of transparency requirements.

• Increased access to customer data by investigators in order to

improve effectiveness of efforts to combat the financing of

terrorism.

• Further extension of the scope of permissible business for mutual

funds.

2003 Investment Modernisation Act

• Permits the authorisation of hedge funds in Germany.

• Provides a high degree of protection for private investors, by

stipulating that hedge funds may only be sold publicly when

complying with certain risk diversification regulations.

• Earlier differences between domestic and foreign investment funds

have been largely eliminated.


116

ANNEX CINFRASTRUCTURE 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

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are documented in the form of a global certificate (a collective cer-

tificate for a given number of securities). This system reduces print-

ing and storage costs. It does not weaken investor protection, since the

law of property continues to apply unchanged.

• Equal treatment of debt register claims (“dematerialized securities”):

Bonds issued by the federal government and the Land governments

are no longer securitized in the form of physical certificates but are

entered into a register maintained at the Federal Securities

Administration. Under the Federal Securities Administration Act,

debt register claims are treated legally as physical certificates.

Exchange-traded securities transactions are settled two days after execu-

tion of the trade. This relatively short (by international standards) settlement

cycle considerably reduces the risk that a counterparty to an outstanding trans-

action will fail to perform on the settlement date. A potential cost associated

with the system is the cost of replacing the original transaction with a new one

at possibly different current prices. As a rule, securities are settled on a deliv-

ery versus payment basis: securities are initially booked provisionally the night

before the day on which the cash settlement is performed (settlement date).

Only with the transfer of funds on the settlement date do transactions become

final. The legal simultaneity of these two steps eliminates the so-called prin-

cipal risk—the risk that the seller of a security delivers a security but does not

receive payment (and vice versa for the buyer).

In cooperation with the Bundesbank and in close consultation with mar-

ket players, Clearstream is currently working on a prefunding system. Under

this system, central bank money would be guaranteed for the settlement of

securities the evening before they are booked. In this way, the irrevocable and

final settlement of monetary and securities transactions could be achieved

simultaneously and overnight. The prefunding system would eliminate the

current unwinding risk . Both the money and the securities would be avail-

able to the market in the early morning of the settlement day before the pay-

ment systems opened.


118

ANNEX DCHRONOLO GY OF THE MOVE TOWARD CASHLESS PAYMENTS,1959–2001Year Event1959 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.

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Start of operation of the Bundesbank’s hybrid Electronic Clearing

with File Transfer System (later Euro Access Frankfurt).

1993 Agreement of the banking industry on the conversion of paper-based

credit transfers into data records by optical character recognition.

Agreement on debit card procedure without entering a PIN and with-

out a guarantee but including a check of the card’s validity.

Introduction of the routing system for the electronic counter (later

Euro Link System) and of the general obligation to convert direct

debits into data records irrespective of the amount.

1994 Agreement on truncated check collection procedure for checks above

a certain limit with the physical presentation of the check to the

drawee banks (since 2002 the minimum has been €3,000).

1997 Introduction of a comprehensive obligation to convert paper-based

instruments into data records; discontinuation of conventional

clearing.

Agreement on home banking; introduction of a single communica-

tion standard for home banking.

1998 Start of ensured same-day settlement of credit transfers whose sub-

mission and delivery is conducted via data telecommunications.

1999 Trans-European Automated Real-Time Gross Settlement Express

Transfer (TARGET) system becomes operational.

2001 Introduction of the liquidity-saving Real-Time Gross Settlement

System (RTGSplus); discontinuation of Euro Access Frankfurt.


120

NOTES

1. At the end of 2001 this ratio amounted to 391 percent for Germany and395 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 anunderlying 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 collectingredemption and interest yields.

5. Minor restrictions exist for specific kinds of collateral that remain in thedebtor’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 toensure 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 atthe central bank (the minimum reserve requirement) stabilizes the banking sys-tem’s demand for central bank money. The requirement makes it easier for thecentral bank (in this instance, the Eurosystem) to assess and provide liquidity tothe market.

REFERENCE

Group of Ten. 2001. “Report on Consolidation in the Financial Sector.” January.Basle.

GERMANY

121

INDIAIndia 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.

POST-INDEPENDENCE INSTITUTION BUILDING

The entire process of institution building in the post-independence period

revolved around India’s need to mobilize savings to raise the investment rate

and channel resources to agriculture and industry. The vision was to ensure

that sectoral needs of credit to agriculture and industry were met in an orga-

nized manner. The commercial banking system was expanded to meet such

general banking needs as accepting deposits and extending short-term work-

ing capital to industry.

To cater to the long-term financing needs of industry at the national level,

and in the absence of a well developed capital market, development finance

institutions were established for catering to long- and medium-term project

financing needs of the industrial sector under the majority ownership of the

RBI.1 The RBI also set up a mechanism to provide concessional finance to

these institutions. State finance corporations were created to cater to the long-

term needs of industry at the state level. The financing needs of the rural agri-

culture sector were fulfilled by a three-tier cooperative banking structure

complemented by urban cooperative banks at the urban sector level. The accel-

erated pace of public investment and industrialization during the late 1950s

and the early 1960s created conditions for stepping up private investment in

industry. The Unit Trust of India (UTI) came into existence in 1964, also

122

INDIA

123

BOX 1

SELECT CHRONOLOGY ON DEVELOPMENTSIN THE INDIAN FINANCIAL SECTOR

Year Event1770 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 andpreventing 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)


124

BOX 1 CONTINUED

1991 Report of the Committee on the Financial System, which pro-vided the blueprint for first generation financial sectorreforms.

1992 Prudential norms introduced for income recognition andasset classification.

Securities and Exchange Board of India obtains statutorypowers to promote orderly development of capital market.

National Stock Exchange incorporated as the first screen-based and transparent trading platform for investors.

Auction system introduced for government securities.1993 Depositories introduced.1994 Board for Financial Supervision, an autonomous body under

the aegis of the Reserve Bank of India, established.New guidelines for entry of new private sector banks

announced.Wholesale debt market operations initiated by the National

Stock Exchange.1996 Institute for Development and Research in Banking Tech-

nology established.Depositories Act passed allowing for holding of securities in

dematerialized form.1997 RBI (Amendment) Act promulgated to intensify regulation

of deposit-taking nonbank financial companies.Automatic monetization of government deficit terminated.Bank Rate activated as a signaling rate.Statutory liquidity Ratio reduced to 38.5 percent (legal min-

imum).1999 Insurance Regulation and Development Act passed allowing new

players or joint ventures to undertake insurance business.Detailed guidelines on risk management in banks announced.Standing Committee on International Financial Standards and

Codes set up to draft sound standards based on recognizedbest practices.

2000 Guidelines issued on interest rate swaps and forward rate agree-ment to enable financial entities to hedge interest rate risk.

New guidelines for categorizing and valuing banks’ invest-ment portfolio announced.

Liquidity adjustment facility introduced.2000 Foreign Exchange Management Act replace Foreign Exchange

Regulation Act.

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

2001 Credit Information Bureau of India Ltd established.2002 Revised guidelines announced for entry of new private banks.

Securitisation and Reconstruction of Financial Assets andEnforcement of Security Interests (SARFAESI) Act adoptedto enforce of security interest for secured creditors.

First universal bank established.Clearing Corporation of India Limited becomes operational.Consolidated guidelines issued on foreign direct investment

in banking.2003 Central Listing Authority constituted.

125

expansion and channeling credit according to plan priorities. To meet these

broad objectives, banking facilities were made available in uncovered areas. In

April 1980 six more private sector banks were nationalized, further extending

public control over the banking system.

By the mid-1970s, it was felt that the task of providing agricultural credit

on the requisite scale could not be met by commercial banks unless they

acquired specialized knowledge of the rural setting. So regional rural banks

were set up in 1975 to fill the gap in financing. By the end of 1975, three sep-

arate institutional arrangements—commercial banks, cooperative banks and

regional rural banks—known as the multiagency approach for providing

credit in the rural areas emerged.

Establishing the National Bank for Agriculture and Rural Development

(NABARD) in 1982 was an important landmark in the history of cooperative

credit. The objective of NABARD was to create institutional arrangements at

the national level for financing, coordinating, guiding and controlling the

cooperative credit system. To facilitate this, NABARD was given certain regu-

latory control over rural credit cooperatives.

In order to give specialized and focused attention to different segments

of industry, certain other specialized financial institutions came into existence

since the 1980s that could be included in the genre of development financial

institutions.

There were attempts to develop the capital market during the 1980s by

increasing participants and instruments, improving transparency, reducing

transaction costs and ensuring safety in settlement procedures. Companies

faced severe constraints in raising money through equity with the tight regu-

lation. Issuing capital through the equity route, debentures and public bonds

emerged as new instruments for raising resources in the primary market. The

secondary market also witnessed an increase in the number of stock

exchanges, listed companies and market capitalization. As the stock markets

developed, efforts were diverted toward providing greater transparency and

investor protection. Several specialized institutions, such as credit rating agen-

cies and custodial service provider companies, also took shape during this

period. The most important development during this period was the setting

up of the Securities and Exchange Board of India in 1988.

The government securities market was mainly a captive market dictated by

the borrowing needs of the government. Banks were required to hold a certain

share of their liabilities in the form of government securities. This statutory

liquidity ratio was increased gradually as the government’s borrowing needs


126

increased. To facilitate its large borrowing requirements, interest rates on gov-

ernment securities were kept artificially low. The provision of fiscal accom-

modation through ad hoc Treasury bills (taken by the RBI on tap at a fixed

interest rate of 4.6 percent) led to high levels of monetization of fiscal deficit

during most of the 1980s. The money market, intended as a market for equi-

librating the demand and supply of funds in the interbank market, was narrow

and relatively illiquid, with control over interest rates. It was only in the late

1980s that the interest rate of the interbank call money market was deregulated

and new instruments like commercial paper and certificates of deposit were

introduced.

The dominance of the public sector and state ownership persisted during

the 1980s. Capital markets were controlled, making transaction costs high.

The government securities market was a captive market for raising debt for the

government, and the money market was restricted to the interbank call money

market, where interest rates were controlled for most of the 1980s. This con-

trol resulted in several inefficiencies creeping into the banking system. On the

eve of the reforms in 1991, the statutory liquidity ratio and cash reserve

requirement together preempted as much as 63.5 percent of the banks’ deploy-

able resources. Such quantitative restrictions as branch licensing and limits on

new lines of business, as well as inflexible management structures, severely

constrained the operational independence and functional autonomy of banks.

Inflationary expectations and inequitable tax structures exacerbated strains on

the exchequer. In addition, widespread market segmentation and constraints

on competition exacerbated the already fragile situation. The market for short-

term funds was reserved for banks, and the market for long-term funds was

the exclusive domain of development finance institutions. Direct access by

corporate borrowers to lenders (disintermediation) was strictly controlled,

and nonbank financial companies were allowed to collect funds only for

corporates.3

External sector problems in the early 1990sThe adverse developments of the 1980s, coupled with the balance of payments

crisis after the 1990 Gulf War, the erosion of public savings and the public sector’s

inability to generate resources for investment, rapidly brought forth the imper-

atives for financial sector strengthening in India. The Indian approach to finan-

cial sector reforms is based on pancha sutra or five principles (Reddy 1998):

• Cautious and proper sequencing.

• Mutually reinforcing measures.

INDIA

127

• Complementarity between reforms in the banking sector and changes

in fiscal, external and monetary policies.

• Development of financial infrastructure.

• Development of financial markets.

Several initiatives were undertaken in the second half of the 1980s to mit-

igate the rigors of the control regime, such as reducing direct tax rates, expand-

ing the role of the private sector and liberalizing licensing controls. But these

changes were marginal, amounting more to loosening of controls and oper-

ation rather than elimination. The economy’s strong response and the accel-

eration of growth in the 1980s created a strong presumption in favor of

evolutionary change. While the crisis of 1991 favored bolder reforms, the pace

had to be calibrated to a democracy.

Structural adjustment measures were undertaken simultaneously with the

liberalization program to harness the stabilizing influence associated with cer-

tain measures of liberalization. Macroeconomic stability was a concurrent pur-

suit. Fiscal and external sector policies supported monetary policy in

maintaining overall balance. The exchange rate was made flexible, foreign invest-

ment was permitted, and the current account was made fully convertible.

Prudential regulations were put in place to ensure safety and soundness, while

transparency and accountability in operations were aimed at restoring the cred-

ibility of the banking system. Recognizing the interlinkages between the real

and financial sectors, wide-ranging reforms were also undertaken in the real

sector so that financial intermediation kept pace with underlying economic

activity.

THE REFORM YEARS: 1991–2004The reform in the financial sector was attuned to the reform of the economy,

which was opening up. Greater opening up underscores the importance of

moving to international best practice quickly because investors tend to bench-

mark against such best practices and standards. Since 1991 the Indian finan-

cial system has been radically transformed. Reforms have altered the

organizational structure, ownership pattern and domain of operation of

banks, development finance institutions and nonbank financial companies.

The main thrust of financial sector reforms was the creation of efficient and

stable financial institutions and markets. Reforms in the banking and non-

banking sectors focused on creating a deregulated environment, strengthen-

ing the prudential norms and the supervisory system, changing the ownership

pattern and increasing competition.


128

The policy environment enabled greater flexibility in the use of resources

by banks through reduced statutory pre-emptions. Interest rate deregulation

gave banks greater freedom to price deposits and loans, and the RBI moved

away from micromanaging banks on both the asset and liability sides. The

focus was on tighter prudential norms in the form of capital adequacy ratio,

asset classification norms, provisioning requirements, exposure norms, trans-

parency and disclosure standards. Greater flexibility and prudential regulation

were fortified by “on-site inspections” and “off-site surveillance”. The high-

powered Board for Financial Supervision was created in 1994 to supervise

and inspect banking companies, financial institutions and nonbank financial

companies. Because of the developing state of the financial system, supervi-

sion of banks, financial institutions and nonbank financial companies rests

with the RBI.

CompetitionIt 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,

INDIA

129

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.

Capital adequacy and government ownershipInternationally, banks follow the Basel norms for capital adequacy. In India

banks were required to phase in these norms for maintaining capital. But as a

result of past bad lending, a few banks found it difficult to maintain adequate

capital. Subsequently, over 1992/93 to 2002/03, the government contributed

more than Rs.220 billion toward recapitalizing nationalized banks. Because of

limited resources and many competing fiscal demands, the government per-

mitted banks that were in a position to raise fresh equity to do so in order to

meet their shortfall in capital requirements. Due to improvement in profits,

some of the public sector banks have returned capital to the government (RBI

2003). At present, government shareholding in public sector banks cannot be

lower than 51 percent.

Institutional innovations for recovery managementThe most critical condition for improving the profitability of banks is a reduc-

tion in the level of nonperforming loans. At end-March 2004 the gross non-

performing loans of the commercial banking system stood at 7.2 percent of

total advances; the net nonperforming loans stood at 2.9 percent of net

advances. The RBI, along with the government, has initiated several institu-

tional measures to contain the level of nonperforming assets. Notable among

these include debt recovery tribunals, Lok Adalats (people’s courts) and asset

reconstruction companies. Settlement advisory committees were formed at the

regional and head office levels of commercial banks. A corporate debt restruc-

turing mechanism was institutionalised in 2001 to provide a timely and trans-

parent system for restructuring large corporate debts with banks and financial

institutions. The corporate debt restructuring mechanism was revised after the

announcement in the 2002/03 Union Budget. While several measures, as men-

tioned above, have been undertaken toward preventing the accumulation of

nonperforming assets, in the absence of creditor rights, the problem tended

to persist. In order to address this aspect, the Securitisation and Reconstruction

of Financial Assets and Enforcement of Security Interest (SARFAESI) Act was

enacted in April 2002. The act empowers secured creditors to enforce any

security interest credited in its favor without any intervention of court or


130

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).

Role of information technologyOperating in a globalized environment requires a high level of technological

development. The RBI has made concerted efforts to develop a safe, secure and

efficient payment and settlement system to enhance financial stability. In the

process of improving the overall efficiency of the payment and settlement sys-

tems in the country, the RBI, apart from performing regulatory and oversight

functions, has also undertaken promotional and institutional activities. A holis-

tic approach has been adopted to design and develop a modern, robust, effi-

cient, secure and integrated payment and settlement system taking into account

certain aspects relating to potential risks, legal framework and the impact on

the operational framework of monetary policy. The approach to the moderni-

sation of the payment and settlement system in India has been three-pronged:

consolidation, development and integration.

The consolidation of the existing payment systems revolves around

strengthening computerized check clearing, expanding the reach of electronic

clearing services and electronic funds transfer by providing for systems with

the latest levels of technology. The critical elements in the developmental strat-

egy are the opening of new clearing houses, interconnection of clearing houses

through the Indian Financial Network (INFINET) and optimizing the deploy-

ment of resources by banks through a real-time gross settlement system, cen-

tralized funds management system, negotiated dealing system and structured

financial messaging solution. While integrating the various payment prod-

ucts with the systems of individual banks is an area of concentration, it

requires a high degree of standardization within a bank and seamless inter-

faces across banks. Recognizing the need for providing a sound platform for

facilitating the absorption of technology by banks, the RBI had set up the

Institute for Development and Research in Banking Technology in 1996 as an

autonomous center for development and research in banking technology. The

institute set up the country’s financial communication backbone, INFINET,

a wide area network using very small aperture terminals and terrestrial lines.

With the benefits ushered in by INFINET, more products have been intro-

duced by the RBI, using INFINET’s backbone. These include the negotiated

INDIA

131

dealing system, which provides screen-based trading of government securities,

and the Real-Time Gross Settlement (RTGS) system, which provides one-to-

one settlement of funds flows on a continuous or real-time basis. At the apex

of the institutional structure for technology improvement in the RBI is the

National Payments Council. Constituted in May 1999, the council is entrusted

with laying down the broad policy parameters for designing and developing

an integrated, state-of-the-art, robust payment and settlement system for the

country.

The RBI commenced implementation of the RTGS system in a phased

manner. As a first stage, a demonstrable version of the RTGS system was

implemented in June 2003, and hands-on practice was given to the officials

of 104 banks. The live operations of the RTGS system commenced on 26

March 2004 with the participation of four select banks. This system is fully

integrated with the integrated accounting system of the RBI. As RTGS services

will be offered by banks through their branch network, it is essential that

banks should put in place necessary connectivity between their branches and

the payment system gateway through which banks will interact with the RTGS

system.

As of 19 November 2004, there were 94 direct participants, including

banks, with 1,435 branches located in 142 cities and towns, conducting trans-

actions on the RTGS system. The coverage is expected to increase to 3,000

branches in 275 centers by December 2004. With a view to helping banks to

efficiently manage their funds and to eliminate avoidable movements of funds

around various centers for settlement purpose, the RBI is likely to introduce

a national settlement system in a phased manner. It will link up different

clearing houses managed by the RBI and other banks at one centralized place.

It is likely to be operational in early 2005. The RTGS arrangement also enables

banks to ensure transfer of funds instantaneously among the member banks

of the system all over the country through an electronic transfer mechanism,

availing the benefit of pooling funds at different centers for optimum uti-

lization. Recognizing the critical importance of the backup and disaster recov-

ery management systems, two geographically dispersed sites were identified

as backup and disaster recovery during 2003/04, and data centers are being

set up at these locations. The RTGS system provides for an electronic-based

settlement of interbank and customer-based transactions, with intraday col-

lateralized liquidity support from the RBI to the participants of the system.

The RTGS system has also been enabled for straight through processing of

customer transaction without manual transaction.


132

Reform of development finance institutionsAlong with the changed operating environment for banks in a globalized sce-

nario, the regulatory framework for development finance institutions has changed

significantly. On the supply side, development finance institutions’ access to low-

cost funds has been withdrawn, and on the demand side, they have to compete

with banks for long-term lending. Development finance institutions have reacted

to these developments by raising funds at competitive rates from the market

through public issue and increasingly through private placements. Likewise, sev-

eral development finance institutions have witnessed an erosion of their asset

quality, especially when the industry has been affected by downturn, transforma-

tion, mergers or sizable exposures. Faced with rising resource costs and increased

competition, development finance institutions have diversified into parabanking

activities (merchant banking, advisory services). As a consequence, there was a

general decline in their term-lending operations, while their short-term lending

and non-fund-based operations increased. Several development finance institu-

tions have proactively responded to the new operating environment.

Divestment of RBI ownership in financial institutionsThe RBI currently holds shares in the National Housing Bank, the Infra-

structure Development Finance Corporation, the Deposit Insurance and

Credit Guarantee Corporation, the National Bank for Agriculture and Rural

Development and the Bharatiya Reserve Bank Note Mudran Limited, a cur-

rency printing press. The RBI has already initiated transfer of ownership in the

Infrastructure Development Finance Corporation, National Housing Bank

and the National Bank for Agriculture and Rural Development to the gov-

ernment. The RBI has proposed framing a new act to make it consistent with

financial sector liberalization, converting the Deposit Insurance and Credit

Guarantee Corporation into the Bank Deposits Insurance Corporation to

effectively deal with depositor risk and distressed banks.

Reforms for nonbank financial companiesTo strengthen the regulatory framework for nonbank financial companies,

the RBI (Amendment) Act, was promulgated in 1997. This thrust of regula-

tion since 1998 essentially focused on nonbank financial companies’ accept-

ing public deposits. To buttress regulatory measures, the nature and extent of

supervision was reoriented based on three criteria:

• Size of the nonbank financial company, defined by the ratio of assets

to income.

INDIA

133

• The type of activity performed, including loans, hire or purchase,

investment and equipment leasing.

• The acceptance or otherwise of public deposits.

A three-tier supervisory mechanism, based on on-site inspection, off-site

surveillance and external auditing was instituted. The regulatory focus is being

gradually aligned to enable the sector to operate on healthy lines and to safe-

guard depositors’ interests.

Insurance reformsInsurance 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.

Reforms in the capital marketThe Indian capital market opened to foreign institutional investors in 1992.

The reform process included structural transformation of the capital market

to bring it in line with developed country counterparts. Since 1992 reform

measures have focused on regulatory effectiveness, boosting competitive con-

ditions, reducing information asymmetries, mitigating transaction costs and

controlling speculation in the securities market. In addition, the Capital Issues

(Control) Act, 1947 was repealed in 1992, paving the way for market forces in

determining price of issue and allocating resources for competing uses. To

increase transparency and anonymity while lowering transaction costs, the

“open outcry” system prevalent earlier was replaced with “screen-based trad-

ing”. The National Stock Exchange of India Ltd. was incorporated in 1992 to

provide equal access to investors from across the country. In 1995 the Stock

Exchange, Mumbai (BSE) also shifted to a limit order book market. To ensure

free and speedy transferability of securities, the Depositories Act, 1996 was

adopted. Dematerialization of securities was started in the depository mode.

It also provided for the maintenance of ownership records electronically by

book entry without making the securities move physically from transferor to


134

transferee. Another important development under the reform process was the

opening of mutual funds to the private sector in 1993/94.

Reforms in the debt marketIn the initial reform years, the objective was to build up institutional and mar-

ket microstructure, and the RBI promoted institutions for developing money

and government securities markets. The strategy was to avoid the moral hazard

problem of the lender of last resort and the conflict among ownership, regula-

tion and supervision. Thus, the RBI promoted the Discount and Finance House

of India Ltd. to activate and deepen the money market, and the Securities

Trading Corporation of India Ltd. to develop an active secondary market for

government securities and public sector unit bonds. The RBI has since disin-

vested its holdings in the Discount and Finance House of India and the Securities

Trading Corporation of India. The RBI also appointed primary dealers, with liq-

uidity support, to act as “market makers” and to underwrite government secu-

rities. To widen the market and infuse foreign funds, foreign institutional

investors were allowed to invest in government-dated securities and Treasury

bills in primary and secondary markets, subject to certain ceilings.While the for-

eign institutional investors increased the number of players in the market, the

institutional innovations sought to increase the number of instruments and

add liquidity to the market. To expand the market to retail investors, the RBI per-

mitted other depositories and clearing houses to open subsidiary general ledger

accounts to facilitate custodial and depository services for foreign institutional

investors in government-dated securities. The government securities market

was recently opened to retail investors through screen-based trading. The RBI

is also supporting technological infrastructure in financial markets for ensur-

ing greater efficiency and transparency in operations and risk-free settlement.

In the process, it has mounted the Negotiated Dealing System and has encour-

aged the setting up of Clearing Corporation of India Ltd.

IMPACT OF FINANCIAL INSTITUTION BUILDING

India’s institution-building process in the financial sector has benefited eco-

nomic development of the country. Liberalization with a social touch enabled

the financial institutions and products to reach out to the various segments

of the Indian population. The process also boosted savings in financial assets

and capital formation.

The impact of deregulation of the financial sector has also been positive.

The efficiency of the financial sector has improved, with cost of intermediation

INDIA

135

reduced, profitability increased and operating expenditure reduced. The sta-

bility of the financial institutions also improved significantly, with the capital

base strengthened and asset quality improved. Product composition, technol-

ogy use and risk-management practices of Indian financial institutions and

markets have also undergone a sea change over the last decade.

Macroeconomic performanceDuring 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.

SCHEDULED COMMERCIAL BANKS

The visible impact of institution building is evident both in terms of widening

as well as deepening of the intermediation process. The banking system has

acquired a wide reach, judged in terms of expansion of branches and the growth

of credit and deposits. Between 1969 and 2003, deposits recorded a compound

annual growth of around 18 percent, credit growth was on the order of 17 per-

cent, and bank offices recorded a growth rate of nearly 6 percent. But growth


136

INDIA

137

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

Table 1

Progress of commercial banking in India, 1969–2003

June June March March March MarchIndicator 1969 1980 1991 1995 2000 2003

Commercial banks 73 154 272 284 298 292Bank offices 8,262 34,594 60,570 64,234 67,868 68,561

Rural and semi-urban bank offices 5,172 23,227 46,550 46,602 47,693 47,496

Population per office (thousands) 64 16 14 15 15 16

Deposits of scheduled commercial banks (billions of rupees) 46.5 404.4 2,012.0 3,868.6 8,515.9 12,808.5

Per capita deposit (rupees) 88 738 2,368 4,242 8,542 12,253

Credit of scheduled commercial banks (billions of rupees) 36.0 250.8 1,218.7 2,115.6 4,540.7 7,292.1

Per capita credit (rupees) 68 457 1,434 2,320 4,555 7,275Share of priority sector

advances in total nonfood credit of scheduled commercial banks (percent) 15.0 37.0 39.2 33.7 35.4 33.7a

Deposits (percent of national income) 15.5 36.0 48.1 48.0 53.5 51.8

a. As at end-March 2002.Source: Reserve Bank of India.

commercial banking sector stood at 13 percent, higher than the regulatory

minimum of 9 percent, implying that the banking sector was well placed with

respect to the capital requirements. This should enable the sector in good

stead to meet the requirements under the new guidelines related to capital

charge for market risk. The overall capital position of public banks has wit-

nessed a marked improvement over the reform period, along with a reduction

in nonperforming loans.

The profitability level of commercial banks as a share of assets was 1.1 per-

cent as at end-March 2004 (table 2). The cost of mobilizing deposits doubled

over 1969–90, and return on loans witnessed a sharper increase over the same

period but decreased after overall interest rates fell. The profile of income and

expenses of commercial banks reveals that interest income has tended to dom-

inate the banks’ income profile. On the expenditure front, the interest expense

component witnessed a sharp rise followed by a gradual drop over the last few

years, in tandem with the soft interest rate regime. Operating expenses have

shown an increasing trend, reflecting the high wage cost of bank employees,

especially in public banks, which comprise the majority of the banking sys-

tem.

Cooperative banksOver 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.

Development finance institutionsThe changes in the operating environment of development finance institutions

have shifted their business profile. A major change in the financing of devel-

opment finance institutions’ investment activity has been the growing impor-

tance of non-fund-based business. The increased access of corporates to

international capital markets has affected development finance institutions’

foreign currency business. The share of underwriting and direct subscription

in disbursements increased sharply over the 1990s, reflecting a diversification

of activities. The asset quality of development finance institutions was


138

INDIA

139

Tabl

e 2

Ear

nin

gs a

nd

exp

ense

s of

sch

edu

led

com

mer

cial

ban

ks,1

951–

2003

(b

illi

ons

ofru

pee

s)

1951

1969

1980

1991

2000

2002

2004

Tota

l ass

ets

11.7

68.4

582.

23,

275.

111

,054

.615

,355

.119

,750

.2To

tal e

arni

ngs

0.5

(3.8

)4.

3(6

.2)

42.3

(7.3

)30

4.0

(9.3

)1,

149.

3(1

0.4)

1,51

0.3

(9.8

)1,

837.

7(9

.3)

Inte

rest

ear

ning

0.4

(3.1

)3.

6(5

.3)

37.5

(6.4

)27

5.2

(8.4

)99

1.8

(9.0

)1,

269.

7(8

.3)

1,44

0.3

(7.3

)To

tal e

xpen

ses

0.3

(2.6

)3.

8(5

.5)

41.8

(7.2

)29

6.6

(9.1

)1,

076.

9(9

.7)

1,39

4.5

(9.1

)1,

615.

0(8

.2)

Inte

rest

exp

ense

s0.

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)

Esta

blis

hmen

t exp

ense

s0.

2(1

.3)

1.4

(2.1

)10

.0(1

.7)

76.0

(2.3

)27

5.8

(2.5

)33

7.0

(2.2

)43

5.0

(2.2

)Pr

ofit

1.4

(1.2

)0.

5(0

.7)

0.5

(0.1

)7.

4(0

.2)

72.5

(0.7

)11

5.7

(0.8

)22

2.7

(1.1

)N

et in

tere

st e

arni

ng0.

3(2

.2)

1.7

(2.5

)10

.4(1

.8)

85.5

(2.6

)30

1.4

(2.7

)39

4.5

(2.6

)56

4.6

(2.9

)

Note

:Fig

ures

in p

aren

thes

es a

re ra

tios

to to

tal a

sset

s.So

urce

:Res

erve

Ban

k of

Indi

a.

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.

Nonbank financial companiesThere is considerable diversity in the composition, structure and functioning

of nonbank financial companies. Their deposits have increased substantially

since the 1970s, in tandem with an increase in the number of reporting com-

panies—from 2,242 in 1969 to 11,010 in 1993. After the introduction of the

new regulatory framework in 1997/98, nonbank financial companies’ deposits

declined markedly.

Insurance companiesThere 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 marketsThe 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

INDIA

141

Tabl

e 3

Sele

ct s

tock

mar

ket i

nd

icat

ors

in I

nd

ia,e

nd

of

Mar

ch,1

961–

2004

1961

a19

71a

1980

a19

9120

0020

0220

0320

04

Stoc

k ex

chan

ges

78

922

2323

2323

Liste

d co

mpa

nies

1,20

31,

599

2,26

56,

229

9,87

19,

644

9,41

35,

528b

Mar

ket c

apita

lizat

ion

(bill

ions

of r

upee

s)12

.027

.068

.01,

102.

811

,926

.37,

492.

56,

319.

212

,012

.0b

a. E

nd o

f Dec

embe

r val

ues

from

the

Stoc

k Ex

chan

ge, M

umba

i onl

y.b.

Dat

a pe

rtain

to th

e St

ock

Exch

ange

, Mum

bai.

Sour

ce:T

he S

tock

Exc

hang

e, M

umba

i and

Nat

iona

l Sto

ck E

xcha

nge.


142

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 marketThe 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.

THE FUTURE OF INDIA’S FINANCIAL SYSTEM

The main focus of the Indian approach remains the creation of an enabling

environment that fosters deep, competitive, efficient and vibrant financial

institutions and market, with an emphasis on stability. Several measures have

been initiated to achieve convergence with international best practices.

Keeping in view the fast pace of technological innovations in the financial sec-

tor and product development at the international level, the focus has been to

bring the Indian financial system up to par with such standards.

Three-quarters of banking sector assets are accounted for by public banks,

with the remaining accounted for by private and foreign banks. The share of

nonpublic banks has been increasing continuously over the last few years, with

a sizable rise in the market share (in terms of assets) being evident for new pri-

vate banks. It is not difficult to imagine that the new private banks, with no

legacy of economic structure and with their ability to leverage technology to

produce highly competitive types of banking, are comparatively better placed

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

INDIA

143

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.

LESSONS FROM INDIA’S EXPERIENCE

Globalization has important implications for the financial sector and the insti-

tutions comprising it. In an increasingly globalized environment, the role of

the policymaker in the domestic institutional building process can be to pro-

vide a stable macroeconomic environment, increase competition, establish a

strong regulatory and supervisory framework, create an enabling legal system

and strengthen technological infrastructure.

Development of the Indian financial system is premised on the conviction

that financial development makes fundamental contributions to economic

growth. The macroeconomic reforms initiated in the early 1990s paved the way

for more market-driven allocation and pricing of resources. Globalization has

tended to exhibit itself domestically, in terms of greater integration of domes-

tic financial markets with global ones, and internationally, in terms of the adop-

tion of a process of gradual convergence with international best practices.

India’s experience suggests that the country was slightly ahead of the

learning curve in implementing reforms in the financial sector. The process

was initiated through high-level committees that provided roadmaps for

implementation to progressively reach international best standards while tak-

ing the country’s unique circumstances into consideration. For instance, in the

first phase, greater emphasis was placed on policy deregulation (interest rate

deregulation, easing of statutory preemptions), improving prudential norms

(imposing capital adequacy ratio, asset classification, exposure norms), infus-

ing competition (permitting entry of new private sector banks), diversifying

ownership, developing money, debt and foreign exchange markets (for


144

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

INDIA

145

institutions are incentive-compatible. An important issue in the design of

institutions is to ensure that incentives that are created actually lead to the

desired behavior. Existing institutions must be modified to complement new

and better institutions.

A well architectured financial system mitigates and diversifies risks. The

challenge to policymakers is to build a financial system that assists in risk mit-

igation. A salient feature of the move toward globalization has been the inten-

tion of the regulators and the responsiveness of the authorities to progress

toward international best practices. Standards by themselves may be presumed

to be desirable, and it is therefore in the national interest to develop institu-

tional mechanisms for considering international standards. Thus, the imple-

mentation of standards needs to be given a domestic focus with the objectives

of market development and enhancing domestic market efficiency.

CONCLUSION

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.

NOTES

1. The definition of a small industry has undergone a transformation over theyears. In 1960, a small industry was defined as one with gross value of fixed assets


146

not exceeding Rs.500,000. This figure has been gradually revised upward andpresently stands at Rs.10 million.

2. The Deposit Insurance Corporation was established by an act of Parliamenton 1 January 1962. With effect from 15 July 1978, it took over the work of theCredit 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 andCredit Guarantee Corporation. The objective was to integrate the twin and relatedfunctions 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 diverseinvestor needs such as hire purchase, equipment leasing and making loans andinvestments. Their major differences with banks are that they are prohibited fromissuing chequeable deposits and that they have limited fixed assets and lessregulation.

4. Under the current norms, the maximum limit on foreign participation inthe insurance companies operating in India is 26 percent.

REFERENCES

India. 1991. “Report of the Committee on the Financial System.” Reserve Bankof 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: AReview. 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 FinancialSector: 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 forMarkets. New York: Oxford University Press.

INDIA

147

INDONESIAGlobalization 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.

BANKING 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.

High inflation: 1966–73In 1966 the New Order Administration launched an economic stabilization

and rehabilitation program to reduce inflation and ensure a sufficient supply

of basic necessities. The administration also worked to reconstruct domestic

infrastructure and carried out various efforts to create export capacity by

adopting a budget policy that limited expenditures to domestic revenues and

counterpart funds from foreign aid. In addition, foreign exchange controls

were removed, and to enhance investment activities, new laws were enacted for

domestic and foreign capital investment. Further, the government began to

148

implement monetary policy primarily through the regulation of credit and

interest rates, characterized by tight credit policies and controlled lending

rates, while increasing deposit rates to encourage savings. These policies helped

reduce the growth of money supply.

Interest rate ceilings: 1974–83Responding to rising inflation stemming from expansion of bank credit and

the 1973 oil shock that increased budgetary receipt and consumption—and

the need to restore economic stability and maintain the pace of economic

development—the government introduced the April 1974 package to stabilize

the financial and monetary sectors. Bank Indonesia began to pursue direct

monetary control by applying a system of individual bank credit ceilings, as a

primary defense against excessive domestic money growth, and by regulating

deposit and lending rates. The central bank provided liquidity credit support

to such an extent that banks could make large amounts of credit available at

low lending rates. It also allocated and extended credit directly to priority sec-

tors. The aim was to ensure that banks in Indonesia were dedicated to their

functions as agents of development. High reliance on liquidity support from

Bank Indonesia had discouraged banks from finding other sources of funds,

particularly from the public.

Banking reforms: 1983–88The extension of liquidity credits financed by the oil boom in the 1970s had

important effects on fund mobilization by the banking sector. Deposit growth

in state banks, where rates were fixed by the central bank, was lower than the

growth of deposits in other banks, which were free to set their own deposit

rates. Accordingly, the extension of liquidity credit from the central bank to

state banks increased significantly.

The deterioration of foreign reserves in 1980, due to lower oil prices,

forced the government to encourage banks to be self-reliant in carrying out

their intermediary role. To this end, the government adopted a broad range

of actions including policies to deregulate the banking sectors. The banking

reform in this period reduced the government’s involvement in stimulating

economic growth and improved the capability of commercial banks in mobi-

lizing savings and deposits.

With the banking deregulation efforts of June 1983, the government began

to remove the remaining interest rate controls on state banks. It abandoned the

system of controlling bank credits through administered ceilings in favor of a

INDONESIA

149

more market-oriented approach relying on indirect monetary instruments.

Bank Indonesia moved to reserve requirements, discount facilities and open

market operations. These fundamental reforms gave rise to satisfactory devel-

opments in the banking sector in terms of both the mobilization of funds and

the extension of credit.

Banking policy adjustments: 1988–mid-1997Bank Indonesia undertook a series of policy measures in the financial, mone-

tary and banking fields in October 1988. The aim was to promote the further

mobilization of funds, develop nonoil exports, enhance the efficiency of banks

and other financial institutions and improve the implementation of monetary

policy and the climate for domestic capital markets. Targeted at banks and

nonbank financial institutions, the new policy allowed the opening of new

branch offices as well as new private banks and rural credit banks. Developing

saving schemes, expanding foreign exchange operations and establishing joint

ventures are also among the new rules set out under the policy measures.

With improved intermediary function, the banking sector succeeded in

supporting strong economic growth for more than a decade before the crisis

in 1997. This was particularly reflected by a rise in the number of banks and

bank offices, the amount of funds mobilized from depositors and the reach of

credits extended to the business sector.

Bank closures and consolidations: 1997–the presentDespite the tremendous growth in the banking sector before 1997, policies

failed to address other weaknesses. The extent of delinquent loans in the state-

owned banks illustrate the degree to which bank loans had been used as vehi-

cles for directed lending to noncommercial ventures. Similarly, the high level

of lending to subsidiaries and other connected entities in many of the private

banks indicate the use of banks as vehicles for channeling deposits to owners

and for expanding business conglomerates. Banking supervision was largely

ineffective, both because of the lack of qualified bank supervisors and because

supervisors were constrained from doing their jobs. While the doors were

opened for the entry of new banks into the industry, no proper exit mecha-

nism was set up for banks that failed to operate profitably.

Furthermore, the absence of some form of deposit insurance scheme, cou-

pled with the moral hazard created by bank owners and their conglomerates as

well as by their close connections to government decisionmakers, constrained

the ability of supervisors to execute their duties properly and close problem


150

banks. These problems remained largely hidden, disguised by the economy’s

fast growth. But, once growth subsided, the true state of the banking sector

quickly became visible. These weaknesses were subsequently unveiled after the

currency crisis, which made these problems complex and difficult to resolve.

At the onset of the crisis, following the floating of the Thai baht on 2 July

1997, the rupiah came under severe speculative attack. After the rupiah was

floated in August, the attacks continued, leading to panic buying and herd

behavior—and to further depreciation of the rupiah by nearly 40 percent

against the U.S. dollar. The Indonesian government finally asked the

International Monetary Fund (IMF) for financial assistance in October 1997.

As part of the measures included in the banking resolution package for-

mulated under the IMF program, the Indonesian authorities closed 16 insol-

vent banks on 1 November 1997. They provided limited deposit insurance for

bank depositors through the extension of liquidity support from the central

bank covering some 90 percent of the country’s depositors—but a far smaller

share (less than 25 percent) of deposits. Along with the growing political

unrest, the wider impact of such bank closures was not anticipated. Aimed at

restoring confidence in the banking system, the closures had the reverse

effect—market panic and bank runs resulting from the absence of clear guide-

lines on depositor protection and comprehensive bank liquidation policies.

Depositors withdrew huge amounts of funds, which were then invested in

risk-free assets (“flight to quality”) or sent abroad (“flight abroad”). Con-

sequently, a number of banks ran into liquidity problems. This situation and

the risk of a complete collapse of the banking system forced Bank Indonesia

to provide liquidity support to the banks affected.

The domestic economic environment deteriorated rapidly, with a further

sharp depreciation of the rupiah leading to rising interest rates, while political

instability increased as rumors about the president’s ailing health spread. Given

these developments and the deteriorating outlook for the country and the bank-

ing sector, foreign banks decided to cut their credit lines to Indonesian domes-

tic banks in response to losses exacerbated by off–balance sheet transactions with

the closed banks. These developments rapidly eroded bank profitability and pub-

lic confidence in the banking sector. By early December 1997 bank runs escalated.

And, in January 1998 the situation in the currency market, the corporate sector,

the banking system and the social and political spheres was near chaos.

In the face of an expanding financial, political and social crisis, the gov-

ernment, including Bank Indonesia, under the renewed IMF program signed

in January 1998, undertook strategic and comprehensive policies to strengthen

INDONESIA

151

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.

NONBANK FINANCIAL INSTITUTION REFORM

In Indonesia the nonbank financial sector consists of securities, insurance, pen-

sion and finance companies.1 The largest and most important of the sector, at

least in terms of the funds involved, is the capital market. But since the crisis both

insurance and private pension funds have been growing rapidly, in excess of 20

percent a year in nominal rupiah (Rp.) terms. Supported by macroeconomic


152

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.

Policy reform history in the nonbank financial sectorThe securities market was reactivated in 1977 but significant reform and activ-

ity began only in the deregulation period (1987–89). The 1987 package sim-

plified share and bond issuance, allowed foreign ownership of 49 percent of

listed shares and introduced a parallel bourse for small cap stocks. The 1988

banking package introduced withholding on interest income and new rules on

legal lending limits, making the capital market more attractive, and allowed

the stock exchange to go public. With these measures, activity in the stock

exchange took off from 24 stock issuers and 8 bond issuers in 1987 to 67 and

22 in 1989.

Between 1989 and 1995 a stock exchange regulator was created

(Bapepam), a credit rating agency developed and gradually technology was

improved to facilitate trading and liquidity in the market. The legal basis was

improved with the passage of a capital market law in 1995, strengthening reg-

ulatory authority, including criminal investigation powers to fight capital mar-

ket fraud. The stock exchange, the clearing and guarantee corporations and the

securities depository were legally defined as self-regulatory organizations.

Open-ended investment funds were introduced, and penalties for market

manipulation and insider trading were increased. The pace of change slowed

during the crisis but later picked up again. Since 2000 scriptless and remote

trading has been introduced. Clearing has moved from t+4 to t+3 and report-

ing requirements have been tightened. Further, an Islamic index was created

and a Syariah bond issued. As part of the government effort to reduce money

laundering and the financing of terrorism, know-your-customer regulations

have been developed and implemented.

The government is an important player in domestic capital markets as

bonds issued to recapitalize the banking system come due. The amounts com-

ing due in 2004 were potentially unstablizing, and one of the government’s key

recent accomplishments has been to address this issue. First, bonds due to the

state banks had their maturities extended at a constant net present value. This

reduced the magnitude of the problem for the next few years. In addition, the

parliament passed a sovereign debt law, and auctions of new debt issues have

INDONESIA

153

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.

Recent developments and problemsCapital market reforms in 1987 and 1988 (and later reforms of insurance and

pensions) were aimed at mobilizing additional capital to support investment

and growth, reduce the dependency on bank and foreign borrowing and

increase the quality and quantity of service to consumers. The 1990s saw rapid

capital inflows in response to these and other reforms, rapid world growth,

greater integration in capital markets and lower returns in a number of devel-

oped countries. The inflows supported high growth in the 1990s—pre-crisis

economic growth averaged well over 7 percent a year.

However, by the mid-1990s exports began to slow, and overheating from

capital inflows was apparent. The government tried to constrain bank access

to international capital through strict enforcement of net open positions and

through jawboning. But there were no policy tools to restrict corporate bor-

rowers from tapping international capital markets and the nonbank financial


154

sector. Indonesian firms with rupiah revenues directly accessed short-maturity

foreign currency loans in foreign markets. When the exchange rate depreci-

ated dramatically, these loans could not be rolled over or repaid. Many of these

companies also had domestic loans that went unpaid as well. Economic prob-

lems spread to the banking sector, and with the systemic failure the economy

contracted by 13 percent in 1998.

Aside from weaknesses in the banking sector, the poor economic response

in Indonesia was also due to underdeveloped nonbank financial institutions.

High domestic interest rates and an inability to access domestic equity and

bond funds prompted firms to turn to short-term foreign debt financing,

which led to currency and maturity mismatches. In some sense this was

inevitable given the relatively late opening of domestic nonbank financial mar-

kets and the amounts of international capital flowing into Indonesia. But poor

governance, insufficiently developed capital markets and global capital flows

combined to make a difficult situation worse.

The post-crisis situation is very different. Most of the largest national

banks are now under new (and often foreign or joint) ownership, and the pri-

vatization of state banks is now under way. This should lead to better gover-

nance and improved assessment of credit risk in the banking sector. Bank

lending has been increasingly concentrated in the retail sector and smaller

firms. This should leave nonbank financial institutions an increasing (and

appropriate) role in supplying capital to domestic firms.

The restructuring of corporations and the existence of IBRA helped

improve the situation. Assets held by IBRA from closed and recapitalized

banks have now largely been sold back to the private sector. Before these sales,

corporations with substantial debt to IBRA were not in a position to access

capital markets. Now they will be, and with legal certainty more corporations

will be able to access capital and no longer have the kind of close affiliation

with banks from before the crisis. Bond issuance by Indonesian corporations

is increasing rapidly, multifinance companies are growing and initial public

offerings are planned.

A fundamental problem lies in the mistrust of nonbank financial prod-

ucts. This is in some part due to legal uncertainty and accounting and report-

ing rules—and in some due to concerns about insider trading, minority

shareholder rights and corporate governance. For every nonbank financial

sector, the government is committed to improving incentives to increase con-

fidence and spur development—a major feature of the policy agenda for 2004

and beyond.

INDONESIA

155

Policy directionsDemand 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

FURTHER INSTITUTIONAL CHANGES FOR THE BANKS

At the national level, there are two priority areas—the need to establish a

deposit insurance institution and a supervision institution for the financial

services sector.

Deposit insuranceIn 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.

INDONESIA

157

Supervision institution for the financial services sectorThe bank supervision function will be transferred from Bank Indonesia to a

new independent institution. With the transfer of this supervision function,

Bank Indonesia will function only as the monetary authority, with its main

task focused on monetary and payment system issues. Notwithstanding, the

central bank still has the authority and responsibility for maintaining overall

financial system stability. The new supervision institution will put more

emphasis on the micro aspects of banking—prudential regulation of indi-

vidual banks and nonbank financial institutions.

The new institution is to be a government institution outside the cabi-

net, accountable to the president. The supervision of the various financial

services companies has been conducted by various institutions that are not

integrated. The existence of many financial services supervisory institutions

has caused overlapping authority and inefficiencies in coordination. With

one institution to supervise overall financial services, it is expected that

supervision over those institutions can be integrated and made more effi-

cient so that a healthy, accountable and competitive financial services indus-

try can be created.

The supervision institution will have the authority to supervise and reg-

ulate, including issuing and revoking business licenses of financial service

management institutions. It will also be given the authority to investigate ille-

gal practices in the financial sector.

It is expected that the new institution will be established by 2006 when the

transfer of banking supervision and regulation from Bank Indonesia will be

conducted gradually.

Complying with the international standardBank Indonesia has conducted a self-assessment of its compliance with the 25

Basel Core Principles for Effective Banking Supervision. To ensure objectiv-

ity, it also requested IMF assistance in performing a similar assessment. These

assessments are expected to support the sequencing of priorities and directions

of IMF assistance to further enhance bank supervision and regulation.

Bank Indonesia initiated a diagnostic assessment as the foundation for a

comprehensive banking supervisory plan—Bank Indonesia’s master plan. This

master plan is to provide a framework for the implementation of the broad

reform efforts necessary to establish a bank supervisory process that fully

incorporates international standards. Bank Indonesia’s objective is to fully

comply with the Basel Core Principles by the end of 2004.


158

Efforts to enhance good corporate governance in the banks started in 1999,

through the establishment of the National Policy Committee for Corporate

Governance. The main task of this committee is to formulate and develop rec-

ommendations for national policies on corporate governance, covering details

on enhancing legal instruments and the structure of institutional support. For

the banking industry, good corporate governance is undertaken among others

through the fit-and-proper tests of bank owners and managers, interviews with

potential bank owners and managers (new entries), appointments of compli-

ance directors and investigations of criminal practices.

FURTHER INSTITUTIONAL CHANGES FOR NONBANK FINANCIAL

INSTITUTIONS

Institutional change in the nonbank financial sector involves broadening the

scope of alternatives to bank saving and lending. The urgency for this increased

in the aftermath of the crisis in 1997. Post mortems indicate that poor gover-

nance and an excessive reliance of Indonesian corporations on debt (espe-

cially foreign-denominated debt) contributed substantially to the depth of

the economic crisis. A domestic capital market that is more open, more diver-

sified, less leveraged, will result in a corporate finance structure that is more

efficient and resilient in the face of future crises.

The crisis also demonstrated the importance of reliable, diversified insur-

ance and pensions, as these have also had to be tapped. Again more—and

more diversified—options are needed. This must be matched by investors

who understand and accept the risks and maturities of different instruments.

The Indonesian workforce is demographically young, but these demograph-

ics are changing, and birth rates are falling rapidly. It is important that insur-

ance and pension products are developed to support workers in their old age.

The government must thus provide a regulatory framework and institutional

structure that has the appropriate incentives, including incentives for trans-

parency and governance.

The crisis also left the government with a large amount of domestic debt.

This debt, now coming due, will need to be refinanced. The annual amounts

coming due may well be in the range of the entire capitalization of the bond

market before the crisis. In addition the parliament has directed the government

to reduce its reliance on foreign financing. So the central government will be a

major actor in domestic financial and especially capital markets. This presents

opportunities—to establish a well defined yield curve, for example. But it also

presents risks—depending on the depth and liquidity of the resulting market.

INDONESIA

159

The central government is significantly decentralizing its authority. This

includes allowing regional governments, under certain conditions, to tap finan-

cial markets. In particular, both the central and regional governments will need

access to domestic capital markets for marginal and long-term project financ-

ing. The development of stronger domestic capital markets should allow for

better maturity matches and reduce financing costs for regional governments.

The government is committed to working with the domestic industry to

improve the institutional architecture, to remove barriers to improve financial

services to meet this challenge without sacrificing the needs of consumers and

firms and especially their access to international markets. This access is criti-

cal to the development of a deep and well balanced corporate structure. So

despite the risks of globalization, the government’s approach is to allow more

competition with international providers, both within Indonesia and outside.

There are consequences, however, to the rapid movement of capital—and

these consequences often fall on those not directly involved. To prevent this

the government is working to put in place an institutional environment that

will reduce implicit guarantees and allow actors to find and accept their own

risk levels. The best defense is strong macroeconomic policy, fiscal discipline,

effective banking supervision, a good legal system and strong and diversified

nonbank financial institutions. Putting these in place is obviously a difficult

task and a longer term goal. But as recovery continues and financial institu-

tions grow, it is important that they grow on solid foundations.

With the macroeconomic situation stabilizing and the fiscal position back

on a sustainable footing, reform in the financial sector, especially in the non-

bank financial sector, is now at the top of the government’s policy agenda.

LESSONS

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

• Third, to best manage globalization, the Indonesian government has

taken the opportunities to redefine the role of the central bank. To this

end, Bank Indonesia is involved in the efforts to establish sound reg-

ulations and effective supervision of financial institutions, to restruc-

ture the banking system, to introduce or amend the bankruptcy law

and the law on competition and to provide adequate information to

financial and other economic agents through the use of technology.

• Fourth, a central bank should provide ample supervision in the bank-

ing sector with highly qualified supervisor.

• Fifth, there is a question about sequencing and timing of the measures

of financial liberalization. For Indonesia, institutional liberalization

(in October 1988) was introduced long before measures for strength-

ening prudential regulations (in February 1991), causing difficulties

in enforcing such prudential measures, especially since the banking

business had already grown.

• Sixth, the institutional liberalization of October 1988 put too much

emphasis on easing entry requirements and procedures into the

banking industry. The exit mechanism, by contrast, was not properly

designed. The absence of some form of deposit protection scheme,

especially for the majority of depositors with small amounts of

deposits, made things worse. Fearing systemic risks from closing a

bank in a centralized and autocratic economic and political system

forced the authorities to nurture problem banks instead of enforcing

a strict exit policy. This implicit guarantee created a moral hazard in

the banking system.

• Seventh, the underdevelopment of nonbank financial markets, espe-

cially those for capital, was caused by—and contributed to—the prob-

lems in banking. Mismatches in maturity and currencies in the banking

system would have been handled better with a better developed capi-

tal markets. But conglomerate banks and corporations reduced the

attractiveness of capital markets, creating a vicious circle.A more com-

prehensive approach might have worked better. Developing bond and

equity markets is now a key government priority.

• Eighth, the potential for asymmetric information is even greater in

capital markets, requiring more certainty in property rights and

transparency. This leads directly to the development of legal and

accounting systems and their enforcement. These areas also have been

a high priority for continuing reform.

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161

• Ninth, insurance and pension funds were more recently opened to

global markets. The issue here is the rapid progress of technology

and the importance of building institutional and regulatory capacity

to avoid the sorts of problems faced in banking. This requires ratio-

nalizing the industries and opening them further to foreign providers,

while gradually integrating them into larger regional markets.

CONCLUSION

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

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.

NOTES

1. Finance companies are not permitted to take deposits, but they are allowedto undertake leasing, factoring, credit cards and consumer finance.

2. Government employees have their own system.

REFERENCES

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 InsuranceIndustry in 2001.” Jakarta.

Indonesia, Ministry of Finance, Directorate of Pension Fund. “2001 AnnualReport 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: theIndonesian 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 andCentral Bank Policies.” Remarks at the Réunion des Gouverneurs desBanques Centrales des Pays Francophones, 23 June, Ottawa.

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163

Santoso, Wimboh. 2000. “Indonesia’s Financial and Corporate StructureReform.” Bank Indonesia, Jakarta.

Schweke, Bill, and Page Brown. “Nation of the Pros and Cons.” Corporation forEnterprise Development, Washington, D.C.

Warjiyo, Perry. 2001. “Bank Failure Management: the Case of Indonesia.” BankIndonesia, Jakarta.

World Bank. 2001. “Finance for Growth—Policy Choices in a Volatile World.”Policy Research Report. Washington, D.C.


164

ITALYOver 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

165

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.

MAIN CHANGES IN THE ITALIAN FINANCIAL SYSTEM DURING THE

LAST THREE DECADES

Two issues lie at the center of analyzing a financial system. The first is what

determines the overall size of the system—or, put differently, the conditions that

facilitate the provision of external finance to the economy. Empirical research

shows that institutional factors—such as the design of the legal framework and

the degree of investor protection, the amount of competition and the sound-

ness of banks and other intermediaries—make a big difference here. The sec-

ond is the relative importance of intermediaries and markets in the financial

system and how markets evolve from one configuration to another.

At the beginning of the 1980s the Italian financial system was not quan-

titatively underdeveloped in comparison with other advanced countries.2 The

volume of gross financial assets has since grown from 0.67 trillion euros to

5.89 trillion euros at current prices and to 1.94 trillion euros in 1980 con-

sumer prices. The ratio of total outstanding amounts of financial assets to

gross domestic product (GDP) increased from less than 4 in 1980 to 7 in 2003.

The financial interrelation ratio has also risen, to stand at 1.14 in 2002.

As in other countries, this reflects increases in the prices of securities and

new liabilities. In the 1990s such issues fell in relation to GDP, more sharply

in Italy than elsewhere. In the quantitative growth of finance, Italy has basi-

cally kept pace with Germany and Japan. The three countries as a group have

seen the gap widen with France (where the financial interrelationship ratio is

2.29), the United States (2.22) and above all the United Kingdom (2.69). But

the British and American financial systems are more oriented to satisfying

international demand. Their financial centers serve not just their domestic

economies—they serve the world.

Competition in the banking markets was fostered by the liberalization

and deregulation measures in the 1980s and 1990s. Among the most impor-

tant in the 1980s, open-ended investment funds were introduced, and credit

ceilings on banks were removed. Geographical and maturity restrictions on

banking operations were also abolished at the end of the decade and finan-

cial flows with the rest of the world were liberalized (Passacantando 1996).

The despecialization of the banking sector was completed with the 1993

Banking Law, which allowed universal banks in Italy.3 The law eliminated the


166

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.

ITALY

167

The composition of financial instruments and the relative importance of

the various issuers have changed considerably in the last 25 years. At the begin-

ning of the 1980s deposits and short-term securities represented more than

40 percent of total financial assets—by 2000 less than 20 percent. Over the

same period shares, mutual fund shares, long-term securities and insurance

technical reserves doubled as a proportion of total financial assets (from 30

percent to 60 percent). The declining importance of banks as issuers was met

by a marked increase in the weight of other financial intermediaries and non-

resident issuers. Among nonbanks the major issuers are now the government

(though declining in importance) and nonfinancial corporations.

The importance of banks in the financial landscape, however, has not

decreased dramatically. Banks play a central role in the Italian financial industry,

and their intermediation model has evolved. Through their group structure they

control a large share of mutual funds.And through the universal banking model

they provide services to firms and finance longer-term investments.

Moreover, new rules for corporate governance introduced forms of direct

protection of minority shareholders, making it easier for shareholders to be

heard. In addition, the new regulation on takeover bids aims to balance the

need for the protection of minority shareholders with the efficiency of the

market for corporate control.

From intermediaries to marketsUntil the 1970s the Italian financial system was oriented more to credit inter-

mediaries than markets, even more than in other countries, particularly in

continental Europe. Leaving aside its complex and debatable qualitative impli-

cations, this simple formula reflected the high or increasing quantitative

importance of banks and the traditional intermediation they performed

directly, as measured by their share of the financial intermediation ratio—the

ratio of the financial assets held by credit institutions (divided into banks and

special credit institutions at the time in Italy) to total financial assets.6

Over the past two decades primary securities—issued by individual spend-

ing sectors not engaged mainly in financial activity (households, firms and pub-

lic bodies) and placed directly with final lenders or their agents (direct

securities)—have grown much faster than indirect securities, those supplied to

final lenders by credit intermediaries drawing on their own purchases of primary

securities. The growth of the securities markets has been correspondingly rapid.

The development of the markets has reflected above all the expansion of

the public debt (from 58 percent of GDP in 1980 to a peak of 124 percent in


168

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,

ITALY

169


170

indirect instruments in the conduct of monetary policy was completed in 1988.

The mobilization of compulsory reserves was introduced in 1990. The creation

of the screen-based interbank deposit market, Mercato Interbancario dei

Depositi (MID), in the same year combined new rules and advanced technol-

ogy. The undertaking by MID participants to concentrate their trades in the

market and the binding nature of quotations contributed to the market’s growth,

transparency and efficiency.

Innovations in the payment system helped reduce the use of correspon-

dent current accounts. There was a positive interaction between monetary

policy and the markets. Monetary policy conducted through the markets

gained in effectiveness and signaling efficacy as the markets developed, while

monetary policy measures and information enhanced the efficiency of the

markets. Strengthened in this way, the Bank of Italy’s monetary policy was

able to manage expectations and subdue inflation between 1994 and 1998,

creating the essential condition for Italy’s political decision to join the single

currency to be implemented. At the same time the proportion of potentially

listable financial instruments actually listed in organized and continuously

operating markets rose from 28 percent to more than 50 percent.

The decline in the financial intermediation ratio, the improvement in

efficiency of the markets and the growth of those markets have a clear mean-

ing: the Italian financial system is no longer predominantly bank-oriented.

But the decline in the relative importance of traditional bank instruments has

not coincided with a decline in the role of the banks, which remain pivotal.

A stock of private capital for the financial industry offering an effective alter-

native to that built up over time by the banking system has yet to emerge.

While deposits and loans were declining in importance, banks developed

their securities trading and administration activities. They accommodated

customers’ demand for portfolio diversification. Taking account not only

deposits but also the securities intermediation by banks directly or through

their securities market subsidiaries and affiliates, the share of financial sav-

ings managed by the banking system has not decreased. It stands well above

90 percent, the level it had risen to in the 1980s from the already very high

80 percent in the late 1970s.

Market participants, instruments and organizational arrangementsAs activity in the markets came to prevail, the instruments, intermediaries

and segments that constitute the financial system changed and in some

respects were enriched. The composition of financial assets shifted radically.

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

The structure of the Italian financial system, 2002 and 2003

End-2002 End-2003Inter- Branches Inter- Branches

mediaries Italy Abroad mediaries Italy AbroadBanks 814 29,926 88 788 30,502 75

Limited company banksa 253 22,924 81 244 23,617 71

Cooperative banks (banche popolari) 40 3,704 7 38 3,471 4

Mutual banks (banche di credito cooperativo) 461 3,192 — 445 3,323 —

Branches of foreign banks 60 106 — 61 91 —Investment firms 158 — — 132 — —Asset management

companies and SICAVs 142 — — 153 — —Financial companies entered

in the register referred to in Article 106 of the ConsolidatedLaw on Banking 1,459 — — 1,494 — —

Entered in the special register referred to in Article 107 of the Consolidated Law on Banking 316 — — 359 — —

— Not available.a. Includes central credit and refinancing institutions.

171


172

is available to cover the range of situations in which all-purpose intermedi-

aries would be unmanageable but which are beyond the reach of intermedi-

aries with a specialized mission. The division of the banking industry into

distinct legal and institutional categories has been overcome with the ending

of maturity specialization.

Alongside the former banks and special credit institutions, the number of

nonbanks operating in the credit sector has increased (to around 1,500) and

their market share has grown. These other credit intermediaries supply leas-

ing, factoring, consumer credit and venture capital services. Their loan port-

folio is now equal to about 10 percent of that of the banks. Life insurance has

expanded. Premium income from the life sector has surpassed that from the

casualty, in part because the life insurance policies sold through the banking

channel now account for about half the total.

Among security market participants, the range of other financial institu-

tions has expanded with the introduction and growth of securities firms, invest-

ment companies with variable capital (SICAVs), investment funds, asset

management companies and pension funds and greater synergy between insur-

ance and financial intermediation (table 2). In addition, more than a hundred

companies established under foreign law are authorized to do business in the

Italian market; they operate investment funds with an 8 percent share of the

total resources under management by the sector.

In 1990 other credit intermediaries together with other financial institu-

tions accounted for 5 percent of gross financial assets in Italy. In 1998 the fig-

ure exceeded 13 percent, thanks especially to the gain of seven percentage

points in the share attributable to other financial institutions. Those institu-

tions had been less developed in Italy than in the other countries of continental

Europe. In 1996 their assets were 35 percent of GDP in Italy, 42 percent in

Germany and 80 percent in France. Three years later the ratio in Italy has risen

to 80 percent; since then it has declined to 75 percent in 2003.

Pension funds have recently been created but their assets are still negligi-

ble. The coverage and generosity of the pay-as-you-go pension plans, and the

consequent modest importance of funded schemes, remain the principal cause

of the delay on this front (table 3). So far, the tax benefits have done little to

accelerate the take-off of these intermediaries.

Ownership and contestability: from public to privateIn 1980, and even a decade later, the activity of public sector banks accounted

for nearly 70 percent of the total volume of business, one of the highest ratios

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

ITALY

Table 2

Asset management companies and SICAVs, 2002 and 2003

End-2002 End-2003Bank investee Bank investee

Total companiesa Total companiesa

Asset management companiesb 142 88 153 93Instituting and managing:

Open-end funds 73 44 71 46Closed-end securities funds 22 14 32 17Closed-end real-estate funds 8 6 11 6Open-end and closed-end funds 13 9 10 6Hedge funds 26 15 29 18

Memorandum items:Companies offering individual

portfolio management 63 43 63 43Companies managing funds

instituted by others 15 10 16 12Companies instituting open

pension funds 15 12 16 13Foreign SICAVs and management

companiesb 250 274SICAVs 175 195

a. Includes Italian SICAVs.b. Companies that market units to the general public in Italy pursuant to Legislative Decree 58/1998, Art. 42.

173

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.

Opening the financial systemProgress in the international integration of the Italian economy and financial

system is reflected in the volume of transactions connected with capital flows

recorded by the balance of payments (the sum of the changes in gross assets and

liabilities). In the 1990s they have increased 10-fold and 16-fold respectively


174

Table 3

Collective investment undertakings, 2002 and 2003

End-2002 End-2003

Total Italian collective investment undertakingsa 1,543 1,556Harmonized open-end funds and SICAVs 1,201 1,142

Equity 609 548Bond and money-market 479 435Other 113 159

Nonharmonized open-end investment funds 218 233Nonreserved funds of funds 179 187Funds of funds reserved to qualified investors 8 8Other nonreserved funds 1 1Other reserved funds 30 37

Closed-end investment funds 61 76Nonreserved securities funds 15 16Securities funds reserved to qualified investors 26 35Nonreserved real estate funds 16 18Real estate funds reserved to qualified investors 4 7

Hedge funds 63 105Funds of funds 53 90

Foreign funds and subfunds marketed in Italy 3,051 3,178

a. Subfunds are considered individually.

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

ITALY

175

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.

The payment systemSince the mid-1980s the payment system in Italy has made quantum leaps in

the efficiency and security of cash and securities settlements, in the technical

infrastructure and in the payment services offered to customers. Settlement

of interbank positions in central bank money has been encouraged, giving

certainty and finality to these transactions and contributing to the growth of

the screen-based interbank deposit market. The volume of transactions set-

tled in central bank money grew from 6 times GDP in 1988 to 41 times in

1998, in line with the EU average of 43. The balances on correspondent cur-

rent accounts declined from 34 percent of total interbank liabilities at the end

of the 1980s to 14 percent at the end of the 1990s.

The changeover from clearing to gross settlement for large-value payments

(the BI-REL system) strengthened the security of payments, substantially


176

reducing systemic risk at a time when transaction volume was growing.

Following the launch of the European Monetary Union, the Italian gross set-

tlement system has been one of the main components of the Trans-European

Automated Real-Time Gross Settlement Express Transfer (TARGET), the

European payment system.14

The creation of central depositories allowed the ownership of securities to

be transferred from one trader to another by book entries on the accounts at

these depositories. The dematerialization of securities was completed with the

measures for the introduction of the euro. The use of automatic trade check-

ing systems in the securities markets made it possible to automate trading and

settlement. The system has coped with the rise in volume generated by grow-

ing financial markets. In 1988–98 the value of the transactions handled by the

securities settlement procedures has increased in constant prices by a factor of

48. In 2003 at 27 times GDP, it was higher than the EU average.

In the stock market the change from securities settlement on predeter-

mined account days to rolling settlement has reduced the interval between

trading and settlement from 15–45 days to 3, in line with European standards.

The use of the BI-REL system for the cash side of the settlement of securities

transactions helped increase settlements on a gross basis to 92 percent of the

total volume of settlements in central bank money at the end of the 1990s.

For retail payments the gaps with other countries in infrastructure and

service efficiency have narrowed. In the last 15 years the number of point-of-

sale terminals has risen from 98 per million inhabitants to 14,900, that of

automated teller machines from 137 per million to 700. This trend has close

the gaps between Italy and other European countries.

The introduction of specialized interbank procedures has shortened the

time for executing cashless payments. New channels of customer contact have

been created as an alternative to the branch network (remote banking) and

innovative products developed for corporate customers (interbank corporate

banking). Customer payments ordered by means of automated procedures

have more than tripled since 1990. And the time required to execute payments

has declined. At the end of the 1980s the average execution time for payment

orders was six days. At the end of the 1990s it was four days for payments of

less than 500 million lire and one day for urgent and large-value payments. The

range of services has been widened with new instruments (electronic money)

and previously little-used instruments (debit and credit cards).

Households and firms so far have made only limited use of the services

now available thanks to the technical and organizational advances of the

ITALY

177


178

payment system. Although the number of cashless transactions has risen, it

remains substantially lower than the European average (56 payments per

capita in Italy, compared with 130 in the EU). The fact that current accounts

are less widespread (0.5 accounts per inhabitant in Italy, compared with 1.4

in other European countries), the fragmentation of the distribution network

and the slower acceptance and use of payment cards explain only part of the

gap, which is also due to the lower propensity of businesses and households

to use innovative payment instruments. At the end of 2000 only 600,000 firms,

or just 14.7 percent, used electronic systems in dealing with their bank; also,

only 3.2 percent of Italian households (4.7 percent in 2002) used remote bank-

ing services. However, the diffusion of remote banking is developing at a fast

pace: in 1996 only 5.5 percent of all Italian firms and 1 percent of all house-

holds were linked to banks through electronic networks or the phone.

Managed savingsThe 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

ITALY

Tabl

e 4

Ass

ets

ofin

stit

uti

onal

inve

stor

s h

eld

by

hou

seh

old

s in

the

mai

n e

uro

are

a co

un

trie

s an

d th

e U

nit

ed S

tate

s,19

99–2

003

End

of p

erio

d da

ta (p

erce

nt)

1999

2002

2003

a

Italy

Fran

ceGe

rman

yUn

ited

Stat

esIta

lyFr

ance

Germ

any

Unite

d St

ates

Italy

As a

sha

re o

f hou

seho

lds’

tota

l fin

anci

al a

sset

sIn

vest

men

t fun

dsb

18.6

8.7

10.1

11.3

12.0

9.1

11.4

11.9

12.3

Insu

ranc

e co

mpa

nies

6.1

21

.8

19.5

7.

0

9.2

28

.9

22.7

9.

1

10.3

Pe

nsio

n fu

nds

0.9

—

1.

9

19.6

1.

0

—

2.0

18

.5

1.0

Ot

her i

nstit

utio

nsc

7.7

—

—

3.

2

8.6

—

—

2.

8

8.3

To

tal

33.3

30

.5

31.5

41

.1

30.8

38

.0

36.1

42

.3

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179

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.

DerivativesAmong 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

interbank transactions and transactions with nonresidents (92 percent and

75 percent of the total, respectively). Euro-denominated transactions, account-

ing for some 90 percent of the total, outweigh those in other currencies.

RECENT DEVELOPMENTS IN THE ITALIAN FINANCIAL MARKETS

The bond marketThe primary market: issuance. Since the first half of the 1990s, the techniques

for allotting government securities have met the most stringent standards. The

base price at auctions was abolished for all Treasury securities between 1988 and

1992. The introduction in 1994 of a category of intermediary called “special-

ist in government securities” has substantially improved the liquidity of the

primary market. The reopening of auctions has enabled an increase in the size

of each single issue. The Italian Treasury has also resorted more to new finan-

cial instruments, such as global bonds, interest rate swaps and currency swaps.

At the end of 2003 the value of outstanding bonds issued by Italian resi-

dents (public sector, banks and firms) amounted to some €1,730 billion, or

133 percent of GDP. Of this, 68 percent had been issued by the public sector,

23 percent by banks and 9 percent by firms. The share of medium- and long-

term bonds was 92 percent of the total ouststanding amount. The average

residual maturity of government securities, which stood below 36 months at

the beginning of the 1990s, increased to about 70 months at the end of the

decade. New bonds from banks and firms, mainly placed on international

markets, accounted for a large share of the total amount of new issues.

The secondary market: organization and integration. Since 1988 Italy has had

an electronic wholesale market for trading government securities (MTS). This

market has rapidly expanded from an initial average daily trading volume of

€150 million to a peak of nearly €21 billion in 1997, stabilizing at around €7.9

billion in 2000 (€8.4 billion in 2003). The impressive growth in turnover in the

middle of the 1990s reflected the exceptionally strong demand for Italian gov-

ernment securities, fueled by expectations of a rapid convergence of medium-

and long-term interest rates on lira-denominated assets to the levels prevailing

in France and Germany (figure 1). In 1994 the introduction of the specialists in

government securities, typically market-makers on MTS, led to a sharp nar-

rowing of the bid-ask spread, which fell from 36 basis points in 1993 to less than

4 basis points in 1999. In 1997 a segment for repo contracts was also introduced.

Market turnover rose rapidly over the years, as intermediaries increased the use

of this instrument for their Treasury management and securities lending, trad-

ing daily almost €49 billion in 2003. In 2000 trading on the MTS accounted for

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).

The stock marketSince the beginning of the 1990s the pace of innovation on the Italian Stock

Exchange has increased substantially (table 6). In 1991 a screen-based con-

tinuous auction trading system was introduced, together with a market for

block trades. The futures and options markets were launched in 1994 and

1995 respectively, while the changeover to rolling settlement was completed

in 1996. Liquidity, transparency and speed of execution were further enhanced


182

MTS MOTa

Figure 1. Yearly turnover, 1989–2003a billions

0

1,000

2,000

3,000

4,000

5,000

6,000

2003200220012000199919981997199619951994199319921991199019890

30

60

90

120

150

180MOT

MTS

a. From 1999 MOT and Euromoney.Source: National statistics.

ITALY

Tabl

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,199

6–20

03

1996

1998

1999

2000

2001

2002

2003

a

Germ

an b

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596,

390

1,21

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91,

402,

122

1,32

3,84

21,

612,

432

1,73

5,09

62,

337,

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Xb17

2,42

41,

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158

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2,12

21,

323,

842

1,61

2,43

21,

735,

096

2,33

7,02

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FFE

423,

967

155,

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224,

366

145,

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9236

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78,3

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9,12

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163

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1,56

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1,04

4,60

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891

1,49

4,42

81,

694,

061

1,91

7,20

41,

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096

2,33

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3

— N

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and

EURO

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T.

183


184

Table 6

Italian stock market indicators (end of year), 1999–2003

1999 2000 2001 2002 2003

Listed Italian companies 264 291 288 288 271On the Nuovo Mercato 6 39 44 44 41

Total market capitalizationa 726,566 818,384 592,319 457,992 487,446On the Nuovo Mercato 6,981 22,166 12,489 6,438 8,265As a share of GDP (%) 65.6 70.2 48.6 36.3 37.5

By sectorb

Industry 20 21 23 25 23Insurance 11 14 13 11 12Banking 23 25 23 22 26Finance 3 3 3 3 4Services 43 37 39 39 35

Gross share issuesc 22,543 9,148 6,171 3,894 8,710On the Nuovo Mercato 280 4,402 222 115 5

Market value of newly listedcompaniesd 189,822 29,764 10,554 5,142 1,412

Foreign companies 119,415 0 0 2,067 0On the Nuovo Mercato 1,345 22,108 458 0 0

Dividends distributede 10,052 15,711 15,889 18,650 17,030Earnings/price ratio (%)f 3.4 4.5 6.0 5.9 6.4Dividend yield (%)f 1.5 2.1 2.8 3.8 3.4

TurnoverSpot market g 504,070 845,193 620,004 572,940 580,703MIB30 index futures 905,841 984,392 829,416 673,836 527,024MIB30 index options 264,181 323,166 246,555 176,513 153,998

Annual change in prices (%)h 22.3 5.4 –25.1 –23.7 14.9Turnover ratio (%)i 83 109 88 109 123

a. Italian companies; at end of period. b. Excludes the Nuovo Mercato and the Mercato Ristretto. c. The valueof share issues is obtained by multiplying the number of shares issued by the issue price. d. Sum of the mar-ket values of each company at the IPO price. e. Source: Mediobanca. Total gross dividends for the financial yearpreceding that indicated in the table. f. Source: Thomson Financial. Current earnings and dividends. g. Italiancompanies. h. Change in the MIB index during the year. i. Italian companies. Share of average market capital-ization for the year.

by the abolition of the stockbroker monopoly, the liberalization of commis-

sions and the requirement to trade on the official market.

The laws on takeover bids and insider trading enacted in 1992 and rein-

forced in 1998 by the Single Act on Financial Intermediation increased the

contestability of control of listed companies and the protection afforded to

minority shareholders. The Nuovo Mercato, established to facilitate the list-

ing of innovative companies with high growth potential, began to operate in

June 1999. New screen-based segments for covered warrants and after-hours

trading were launched in February and May 2000, respectively. More recently

the STAR segment was created, aimed at medium-capitalization enterprises

that meet higher requirements for liquidity, corporate governance and

information provided to customers. In addition, the Expandi market was

inaugurated in 2003, aimed at encouraging the listing of small and medium-

capitalization companies. In March 2004 there were 11 companies listed on

the Expandi market, with a market capitalization of €4.6 billion.Despite the

organizational improvements, the size of the Italian stock market relative to

GDP is smaller than in other major countries.

Pagano and others (1998) analyze the reasons behind the reluctance of

Italian firms to go public. Company size is a very significant determinant of

listing, suggesting that the fixed costs of listing may explain the decision not

to go public. Such costs are likely to be important if one goes beyond the

mere out-of-pocket expenses incurred in obtaining and maintaining the list-

ing, but extends to the broader implications of complying with much more

demanding information disclosure (including the likely substantial curbing

of tax avoidance opportunities) resulting from stock market scrutiny and

appraisal. Indeed many young companies do not use the stock market to

finance their expansion, resorting instead to other source of external finance,

typically bank loans, which might be more efficient if the costs of trans-

parency are properly factored in.

Since the second half of the 1990s foreign participation, though limited,

has been increasing. In 2003 it reached 13.3 percent (up from 4.3 percent in

1998). Market liquidity has moved into line with that of the other major Euro-

pean stock exchanges. Turnover increased from 46 percent of average capital-

ization in 1995 to 123 percent in 2003. On the Nuovo Mercato the average daily

turnover in 2000 stood at €116.1 million; it has steadily declined to €30 mil-

lion by 2003. On the derivatives markets, the notional value of futures contracts

on the MIB30 index (the index of the 30 blue chips of the Italian Stock

Exchange) totaled €985 billion in 2000, that of options contracts €323 billion.

ITALY

185

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.

COMPETITION IN THE ITALIAN FINANCIAL SECTOR

Italy’s financial services industry has been undergoing rapid changes, in part

triggered by deregulation and technological advances. These changes have led

to many changes, including disintermediation, removal of barriers between

financial products, consolidation, increased cross-border capital flows, greater

commercial presence and more financial integration, as well as some risks and

short-run costs.

Cetorelli and Violi (2003), using bank-level data and applying an adapted

version of the generalized Cournot-Bertrand competition model, extending

the Neven and Roller (1999) model—estimate the degree of competition for

the euro area banking systems. They find strong evidence that Bertrand-type

of competition is prevalent in the main countries among commercial


186

Index (31 December 1994=100)

Figure 2. Share prices for various indexes, end of month, 1995–2004

50

100

150

200

250

300

350

2004200320022001200019991998199719961995

United States(Standard & Poor’s 500)

Italy(Milano Italia Borsa)

Euro area(Dow Jones Euro STOXX)

Source: Bloomberg.

banks—price competition is fairly strong—and the level of competition does

not differ substantially across countries in the second half of the 1990s.

Banking system concentration, as such, does not seem to matter much.

Such findings confirm that contestability determines effective competi-

tion. They partly differ from Shaffer (2001), one of very few studies using a

large sample of countries (15) in North America, Europe and Asia during

1979–91. Shaffer finds significant market power in five markets and excess

capacity in one. Estimates were consistent with either contestability or

Cournot-type oligopoly in most of these countries, while five countries were

significant more competitive than Cournot. Since the data refer to the period

before 1993, when the European single banking license was adopted, the result

may not reflect the current situation. The Cetorelli and Violi (2003) results also

differ, in part, from those of De Bandt and Davis (2000), who reject both per-

fect collusion as well as perfect competition and find mostly evidence of

monopolistic competition for 1992–96.18

Angelini and Cetorelli (2003) analyzed the evolution of competitive con-

ditions in the Italian banking industry using firm-level balance sheet data for

1983–97. Regulatory reform, large-scale consolidation and competitive pres-

sure from other European countries have changed the Italian banking envi-

ronment substantially. They find some evidence of a substantial increase in

competitive conditions in the banking market after the introduction of the

European Single Banking License, with a decrease in mark-ups.

CONCLUDING 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.

ITALY

187

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.

NOTES

1. For a full description and discussion, see Ciocca (2000); for more detailson 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 realwealth (plant, machinery, stocks, buildings and land)—Raymond Goldsmith’sfinancial interrelation ratio—is estimated to have been 0.9 in 1980. This valuecan be considered high, albeit below the peaks recorded in the 1970s, which wereanomalous in several respects. It was not lower than those recorded in the moreadvanced economies of West Germany, France and Japan.

3. A universal bank can operate without maturity constraints and can carryout all the financial activities that are not restricted by law.


188

4. In 1998, the Single Act on Financial Intermediation was enacted. With thislaw, a new institution was created: the asset management company, which madeit possible to overcome the segmentation of activities and allowed banking andfinancial 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 ofmultiple banking relationships, which reduced the strength of bank-customerrelationships (see Garella and others 2000).

6. Calculated for stocks, the financial intermediation ratio reached a peak of0.5 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 thoseof 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 assetsdeclined continuously, albeit less rapidly, in the two following decades, and by1997 it had fallen below 0.3, lower than the ratio in Germany (which had remainedaround 0.4), similar to those in France and the United Kingdom and higher thanthat 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 thenumber of listed companies, from 134 to 223, and to their issues of new shares. Inthe 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 percentof GDP. Privatized companies account for more than half the growth in the stockexchange since the last quarter of 1993, when the privatization program began inearnest. New share issues by listed companies declined from 8 percent of totalstock 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 andTreasury bills) fell from 44 percent of total financial assets in 1980 to 33 percentin 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 percent20 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 billionin 2003. Between 1990 and 1997, including Italian banks’ branches abroad, resi-dents’ foreign currency deposits plus nonresidents’ lira and foreign currency

ITALY

189

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 oftotal lending. The number of Italian banks’ branches abroad rose from 43 in 1980to around 100 in 1990, and then remained at about that level over the last 10years. That of foreign banks’ branches in Italy has increased uninterruptedly, from24 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 EUgroups. The presence of Italian banks abroad was extended, thanks notably to theacquisition of foreign banks. At the end of 2003, 23 Italian banking groups wereoperating abroad; there were 75 foreign subsidiaries and 80 foreign branches.Branches and subsidiaries located in non-EU countries numbered 50 and 42respectively.

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 outrelative 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 tothat 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 Italianresidents), the time for recovery ranged, for the reference month of December1999, 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 rateis 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 paymentstotaling €925 billion a day. Cross-border transactions increased by 58 percent innumber and 6 percent in value between January and December 1999. The shareof transactions originated by Italian intermediaries is high in terms of number (25percent), 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 derivativesamounted to $207 billion a day in 2003, nearly 10 times the level in 1995. Forwardforeign exchange transactions rose from just under $16 billion in 1995 to justover $155 billion in 2003, essentially owing to the steep increase in foreign


190

exchange swaps, whose share of the total rose from 33 percent to 72 percent. Theshare of total trading accounted for by nonresident counterparts remained basi-cally unchanged at about 75 percent. Daily turnover in exchange rate derivativesgrew 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 doesnot hold. Also Bikker and Groeneveld (2000) find monopolistic competition inall of the 15 EU countries they study.

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Passacantando, F. 1996. “Building an Institutional Framework for MonetaryStability.” 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 andFinance 12(1): 79–104.

Violi, R. 2004. “Tax Systems, Financial Integration and Efficiency of EuropeanCapital Markets.” Ente Einaudi, Quaderni di Ricerche, 58, Rome.


192

JAPANDesigned 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.

DEVELOPMENT OF THE FINANCIAL SYSTEM IN THE

HIGH-GROWTH PERIOD

The goal for the postwar Japanese economy was clear: achieve high growth and

improve national standards of living. To that end, a high priority was placed

on intensive industrialization in light industries (such as textiles) and later in

heavy industries (such as steel, shipbuilding and chemicals).3 This way cou-

pled with steps to foster the advance of coal mining and other energy indus-

tries. This strategy toward industrialization helped Japan catch up with other

developed countries. Indeed, one key feature of postwar Japan is that instead

of relying purely on market forces, the government helped the country reach

parity with the rest of the industrial world by pursuing an active role in mar-

ket economy through regulations and guidance, among others.4

Low interest rates through regulation and the policy of fiscal balance were

pillars of support for the government’s growth policies. On the financial front,

the big questions were how to promote investment and how to concentrate

more capital in strategically important industries. The financial sector was

expected to encourage efficient investment of the nation’s then relatively mea-

ger pool of private savings. Efforts were focused on the cultivation of a bank-

oriented credit intermediation mechanism.5, 6

The main feature of the Japanese financial system in the high-growth

period was its strong orientation to regulate. This was echoed in the use of

administrative guidance to encourage the flow of financing into strategic

industries—and to protect and stabilize banking operations in the interest of

193

facilitating bank-oriented intermediation in national savings. The system of

specialized financial institutions was set up, and strategic financing was imple-

mented on that basis. Meanwhile, deposit rates were generally controlled, gen-

erating rents for the banking sector. Outside the banking sector, restrictions

applied to the cultivation of the bond market, constraining the flow of funds

to and from other countries.

Control of deposit interest ratesDeposit interest rates were controlled to prevent rate competition. These con-

trols avoided unreasonably high lending rates, and also reduced the cost of

export and investment financing.7

Restrictions on the banking businessControls were also placed on participation in the financial system, limiting

competition among banks. The banking business was segmented into various

specialties. City banks provided short-term funding to the nation’s strategi-

cally important industries. Long-term credit banks supplied financing for

long-term capital investments, functioning as an alternative to financing

through the bond market. In the interim, as a fundraising measure, the long-

term credit banks issued bank debentures in denominations smaller than those

for corporate bonds, absorbing savings. The regional banks and credit unions

provided loans to small and medium-size businesses and extended funding to

larger banks through the short-term money market, using the excess capital

remaining from their lending activities. This system effectively prevented any

competition between the regional and large banks.8

The coordination of bond issues and the partitioning of the domestic andforeign marketsIn 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

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.

THE END OF HIGH GROWTH AND THE BEGINNING OF A

TRANSFORMATION IN THE FINANCIAL SYSTEM

In the 1970s, significant environmental changes brought the Japanese econ-

omy to a crucial turning point. First, the phase of rapid economic ascen-

sion had come to an end, and the growth rate began trending downward

(figure 1). Several factors can be cited to explain the decline in growth, but

the most fundamental was the virtual end to the migration of labor from

the agricultural to the industrial sectors. The shift of the labor force from

rural areas to the cities had increased the overall labor supply by expand-

ing the available pool of labor. It also fostered growth in aggregate demand

through a corresponding increase in the number of urban households. But

JAPAN

195

2003199519901985198019751970196519601955

Percent change (y/y)

Figure 1. Real GDP growth, 1955–2003

–3

0

3

6

9

12

15

Period average

Source: Cabinet Office.

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.

Pressure for financial deregulationThe falloff in economic growth, coupled with the accumulation of financial

assets, brought about a change in capital flows (figure 3). Funding in the

corporate sector dwindled. Although savings continued to accumulate in the

household sector, they were absorbed by public finance and the foreign sec-

tor (current account surplus).


196

0

300

600

900

1,200

1,500

2002199519901985198019751970196519601955

Trillion yen

Figure 2. Financial assets of households, 1955–2002


This undermined the simple lending function of financial intermediaries

to the corporate sector and increased demand for asset allocation services.

The increase in private and corporate savings sparked demand for higher

returns on bank deposits, which in turn created pressure to liberalize Japan’s

financial sector. In public finance, slower gross domestic product (GDP)

growth translated into slower growth (or declines) in tax revenue. So the

increased spending on welfare and economic stimulus led to fiscal deficits.

To offset these deficits, the government expanded its reliance on issuing

bonds. Banks purchased government bonds when their volume was still small.

But the expanding volume of issues required that bonds be floated in the finan-

cial markets. Interest rates were accordingly deregulated to improve the appeal

of government bonds as investment vehicles. This expanded the open market and

encouraged the deregulation of rates on bank deposits and other financial assets.12

Pressure to deregulate Japan’s financial sector also came from capital markets

overseas.Heightened business abroad encouraged many Japanese corporations to

invest their asset holdings in foreign capital markets despite a variety of controls

and regulations. Japanese banks also became active overseas and began to express

a desire for global forms of asset management. These globalization trends accel-

erated with the abandonment of restrictions against the conversion of foreign

currencies into yen. Efforts in domestic financial deregulation were also encour-

aged as a means of curbing the “hollowing”of Japan’s domestic financial markets.

JAPAN

197

–15

–10

–5

0

5

10

15

2002199519901985198019751970196519601955

Percent of nominal GDP

Figure 3. Flow of funds, 1955–2002

Household

Government

Surplus

Shortage

Corporate(nonfinancial)

Overseas


The gradual approach in financial liberalizationFaced with such environmental changes, Japan opted for a strategy of grad-

ual adjustments to its financial system while maintaining a degree of order.

The financial liberalization was phased and gradual. For example, the lib-

eralization of deposit interest rates took 15 years, beginning in 1979 with the

lifting of a ban on issuing certificates of deposits. In addition, capital and for-

eign exchange transactions were fully liberalized in 1998, 34 years after the

liberalization of current transactions in 1964.

Also gradual were a lowering or removal of barriers separating the bank-

ing, securities and insurance—and the relaxation of the specialty banking

framework. Although the government began studying financial reforms in the

1970s, opposition from vested interests slowed progress. Fundamental reforms

in this area had to wait until 1996, the year of Japan’s financial Big Bang.

Given that progress in financial reform could also be expected to bring

about a decline in rents from the remaining regulations, banks faced pressure

to improve their profit margins in the new financial market setting. But they

continued to earn rents because of the gradual steps in financial liberalization.

This let them maintain an expansionary lending stance and increase their

lending volumes even during periods of slow growth. Consequently, bank

lending expanded at a pace exceeding macroeconomic growth through the

1970s and 1980s (figures 4 and 5). Although most Japanese banks at that time

were not able to rid themselves of weak profit margins, they did make an effort

to improve their margins in the first half of the 1980s. In the process, they

increased their lending to customers in the real estate sector (figures 6 and 7).

This strategy fueled Japan’s speculative bubble. Real estate prices in Japan

had risen without pause throughout the postwar era. Japanese banks for this

reason proved relatively poor in managing the risk associated with real estate

loans. It can thus be argued that expanded bank lending without adequate

risk management in a climate of gradual rate liberalization bred the seeds of

the speculative bubble. The collapse of the bubble left Japan’s banking sector

saddled with a growing burden of nonperforming loans.

PROVISIONAL 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

199

0

20

40

60

80

100

200019901980197019601950

Share of total (percent) Total lending in trillion yen

Figure 5. Bank lending by sector, 1950–2000

Manufacturing Nonmanufacturing Individual Others

1 9 53 178 411 470

Source: Bank of Japan.

2003199519901985198019751970196519601955

Percent change (y/y)

Figure 4. Growth in nominal GDP and lending outstanding, 1955–2003

–5

0

5

10

15

20

25

30

35

Lendingoutstanding

Nominal GDP

Source: Cabinet Office and Bank of Japan.


200

0

20

40

60

80

100

2000 1990 1980 1970 1960 1950

Share of total (percent)

Figure 7. Bank lending in the manufacturing sector, 1950–2000

Iron & steel General machinery Transportation machinery Electrical machinery Foodstuffs & beverages Chemical products Textile products


0

20

40

60

80

100

2000 1990 1980 1970 1960 1950

Share of total (percent)

Figure 6. Bank lending in the nonmanufacturing sector, 1950–2000

Wholesale & retail trade, eating & drinking places

Construction Electricity, gas, heat supply & water

Transport & communications

Services Finance & insurance Real estate


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

NOTES

1. This paper was prepared by Wataru Takahashi and Shuji Kobayakawa ofthe International Department of the Bank of Japan. The authors thank Hirotaka

JAPAN

201

Inoue, Yohei Kawana, Masao Fujiwara and Yukiko Sakai for their help, commentsand 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 standardsof living improve and the needs of the public diversify. In addition, the hard bud-get constraint successfully prevented many developing countries from getting intofinancial trouble.

5. Allen and Gale (2000) focused on the role of financial intermediaries toalleviate informational asymmetries and drew several conclusions. First, duringthe era of rapid growth, the profitability of the investment opportunities is rela-tively easy to assess. So, bank-centered financing saves the cost of monitoringpotential borrowers. Second, as an economy grows and profitability diversifies, themerit of delegated monitoring diminishes. In that case, various investmentappetites 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. Undersuch circumstances, cultivating a bank-oriented financial system was arguablythe wise choice.

6. The opposite of a bank-oriented financial system is a market-orientedfinancial system.

7. It has been pointed out that lending rates were not held at low levels ifexamined on an effective basis by taking deposit yields into account. In the past,firms were required to hold compensating balance with main banks (demanddeposit accounts that had been required to hold under a low interest rate in com-pensation for borrowing at higher rates). Nonetheless, lending rates were arguablyheld 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 inbank lending.

8. Monitoring was effectively done by specialized financial institutions.

9. Among the more recent cases of economic development, some countrieshave relied on foreign capital—that is, foreign direct investment—to offsetdomestic 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 investmentswith the preferential extension of certain forms of credit. The government wascapable of monitoring the supply of capital to strategically important industriesthrough the lending activities of banks. Additionally, the Bank of Japan usedwindow guidance to encourage private banks to keep aggregate increases in loan


202

volume within limits deemed appropriate. Note, however, that window guid-ance sought to limit aggregate lending by individual banks, and not the amountof lending to individual companies.

11. On the surface, this may appear to be a contradiction. However, whilecompetition 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, bankswere eager to absorb deposits and actively competed for good customers. Thesefactors in turn contributed to improved business efficiency.

12. Open market, as opposed to interbank market, first appeared in Gensakitransactions. As a result, disintermediation in the banking sector became acute.

13. By contrast, direct financing was not suited to the absorption of small-scalesavings 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 ProfessorAoki of Stanford University. Its main feature, in brief, is the assumption thatresource distribution within a given economic system depends on a variety ofsocially supportive structures and institutions, including resource holdings, pub-lic expectations and preferences, corporate technologies, social customs andnorms and the way corporations are organized. Applying the same logic to finan-cial systems leads to the conclusion that resources will be allocated differentlyunder 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 securitizationwhile maintaining the traditional bank-centered system. A classic example wouldbe the sale of a mutual fund by a bank. Despite the current difficulty associatedwith the transition from a bank-centered to market-centered system, effectivelyusing 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 capitalmarkets through securitization will be an important step for Japanese banks thatplan to participate in the securities business.

REFERENCES

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.

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REPUBLIC OF KOREAFinancial 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

205

BOX 1

STRENGTHENING FINANCIAL INSTITUTIONSIN THE REPUBLIC OF KOREA

Institutions provide basic infrastructure and affect overall economicperformance. As Alan Greenspan once noted, along with openness totrade and integration with other economies and successful measuresfor economic stability, efficient institutional infrastructure is one ofthe three pillars of economic growth.

The basic policy of institution building lies in consolidating mar-ket orders to secure self-regulating management of financial indus-tries. Institution building needs to proceed in four stages:

• Restore market credibility by completing financial restructuringand presenting a vision of a desirable system.

• Develop the capital market by introducing long-term financialproducts, and improve the risk management skills of marketparticipants.

• Enhance the infrastructure of finance by improving the economicsystem, deregulating and developing credit evaluation bureaus andinformation technology.

• Develop leading financial institutions in order to make thefinancial industry strategically important.

Korea’s financial reform process The Republic of Korea has pursued financial liberalization since theearly 1980s, but progress has been slow. The most obvious cause ofthe sluggish performance was poor loan screening in the banking sec-tor. Korea’s financial, corporate and public sectors were restructuredafter the introduction of the IMF stabilization package in December1997.

To help the economy ride out the financial depression of 1998,the government injected substantial public funds. It did so after estab-lishing an institutional infrastructure that includes the FinancialSupervisory Commission, the Financial Supervisory Service, theKorea Asset Management Corporation and the Korea DepositInsurance Corporation.

In December 1997 the Financial Industry Restructuring Act wasamended to establish a relevant regulatory framework. The frameworkformally instituted the provision for prompt corrective action. The Acton the Establishment of Financial Supervisory Authorities, enacted inDecember 1997, established the Financial Supervisory Commission (in



206

BOX 1 CONTINUED

April 1998) as an independent consolidated financial supervisoryauthority for banks, security houses and insurance companies.Following the establishment of the Financial Supervisory Commission,the Financial Supervisory Service was introduced to integrate the super-visory authorities. With the birth of this new, unified supervisoryauthority, the activities of all financial institutions operating in theRepublic of Korea were put under more strict and efficient supervision.

The Korea Asset Management Corporation was established inNovember 1997, and a nonperforming loan resolution fund was cre-ated within it to purchase nonperforming loans at financial institu-tions. The same month, the Korea Deposit Insurance Corporationextended a three-year temporary blanket guarantee on deposits offinancial institutions.

The rigorous financial restructuring removed a large number ofinsolvent and incompetent financial institutions from the market. ByJuly 2003, 725 financial institutions—34.5 percent of the institutionsbefore the financial crisis—had been closed or merged. In the bankingsector, 15 of 33 banks had been either closed through purchases andassumptions or merged with other banks. Cost-saving measuresreduced employment in the banking sector by an average of 39 percent.In addition, 1,307 branches (21.8 percent) were closed as of June 2001.

The first-round of restructuring ended with the formation of theFinancial Supervisory Service. The second round was launched inSeptember 2000, with the objective of improving the ownershipstructure and management system of financial institutions. The sec-ond round involved a significant shift in the role of the government.While the first round was under the initiative of the government, thesecond round encouraged active market participation.

The two rounds of restructuring resulted in important institu-tional changes:

• A strengthened prompt corrective action system, based on theBank for International Settlements capital ratio for banks and theoperational net capital ratio for securities companies, is being fullyimplemented.

• All financial institutions are subject to the new disclosure system,with strict penalties for false or dishonest disclosures.

• The deposit insurance system was amended to prevent moralhazard by depositors and financial institutions. Mark-to-marketvaluation of securities is being strongly enforced.

• Loan classification standards and provision requirements havebeen implemented, in conformity with international best

REPUBLIC OF KOREA

207

practices. Forward-looking criteria in measuring asset qualities offinancial institutions were also adopted.

Development of domestic debt and capital marketsSince the financial crisis of 1997, the Korean bond market has under-gone significant changes. First, the bond market grew significantly, asthe government issued bonds to restructure the financial, corporateand public sectors, as well as the labor market. Second, issuance ofnonguaranteed corporate bonds increased considerably, while theissuance of guaranteed corporate bonds sharply decreased. With theincreasing insurance of nonguaranteed bonds, the role of credit rat-ing agencies has become increasingly important. The new system,which introduced the mark-to-market valuation of new funds, newbond lending systems, measures to ensure proper disclosure of bondtrading information and other measures, has accelerated and deep-ened development of the bond market.

Despite significant changes, many problems remain in the capi-tal market. First, rapid growth in both stock and futures markets hasbeen based largely on a few blue-chip stocks and derivatives. Second,settlement costs of trading, clearing and deposit are high, and Koreansecurities companies are small by international standards and haveweak management structures. Third, the Korean market does not havethe necessary structure and basis for risk management. Fourth, theKorean market still lacks a systematic structure of investor protection,so important to investor confidence. Fifth, the secondary market isbased on government bonds and a few superior corporate bonds.

Economic performance after financial reform Effective supervision and regulation of financial institutions can con-tribute to macroeconomic stability. But it is not easy to evaluate theimpact on economic performance, which is affected by many other fac-tors. The Republic of Korea’s experience is a good case study for mea-suring economic performance, because except for its large currentaccount deficit, its fundamentals were sound before the currency crisis.

Before the 1997 currency crisis, the Republic of Korea had pur-sued high economic growth with high inflation for more than fourdecades, accumulating significant foreign debt . Shortly after the cri-sis, the Korean economy went into a severe recession, with GDPdeclining 6.7 percent and inflation reaching 7.5 percent in 1998.

The sweeping financial restructuring of late 1997 and 1998helped revive the real sector. Economic growth in 1999 and 2000 washigh, inflation was low, and the current account recorded surpluses



208

–5

0

5

10

15

20

25

20021995199019851980

Billions of U.S. dollars

Figure 1. Net capital inflows into the Republic of Korea, 1980–2002

Portfolio investment

FDI

Source: Bank of Korea.

BOX 1 CONTINUED

for five consecutive years. The nonperforming loan ratio alsodropped, from 12.9 percent in 1999 to 2.3 percent in 2002, while theBank for International Settlements capital adequacy ratio surged,from 7.0 percent in 1997 to 10.6 percent in 2002.

ConclusionGlobalization and liberalization have been the main factors affectinginstitution 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 finallytriggered significant reform of the financial sector, fully openingfinancial 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 closelyto 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 anddelayed 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 financialinstitutions can pursue profit-oriented management.

Source: Korean Ministry of Finance and Economy.

IMPROVING FINANCIAL SOUNDNESS THROUGH

INSTITUTION BUILDING

In order to establish a sound financial system, the Korean government first laid

the foundation for a stable macroeconomic environment. It ensured the inde-

pendence of its central bank, enhanced the fiscal soundness and transparency

of its financial institutions and introduced a free-floating exchange rate system.

The Financial Structure Improvement Act (December 1997), which simplified

the process of forcing nonviable financial institutions to exit the market, made

financial institutions focus on the sound management of their business activi-

ties. Public disclosure standards were strengthened in order to ensure that infor-

mation on financial institutions was disclosed to foreign and domestic investors

in a transparent manner. At the same time, the financial supervisory authori-

ties changed their focus from regulation of the business operations of financial

institutions to their prudential regulation—by demanding that they achieve

adequate capital ratios and asset soundness, for example. Regular supervision

was also strengthened by introducing prompt corrective action. In addition, the

blanket deposit guarantee system was changed to a partial guarantee system, as

a means of reducing moral hazard at financial institutions.

The Republic of Korea’s experience building a sound financial system can

be assessed by examining the following activities: establishing the environ-

ment for stable macroeconomic operations, establishing a system for market-

based resolution of ailing financial institutions, enhancing the transparency

of financial institutions, setting up a prudential supervisory system and

improving the deposit insurance system.

Establishing the environment for stable macroeconomic operationsTo take full advantage of financial globalization, a country must be able to

respond flexibly to external shocks caused by large unanticipated outflows of

REPUBLIC OF KOREA

209

Table 1

Net inflows of foreign capital into the Korean stock market,1996–98

(Millions of U.S. dollars)1996 1997 1998

Jan.– Jan.–June July Aug. Sept. Oct. Nov. Dec. June

Net inflows 4,373.0 2,174.0 215.2 28.5 365.9 816.0 724.5 323.1 2,815.4

Source: Bank of Korea.

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.

Establishing a system for market-based resolution of ailing financialinstitutionsThe failure of nonviable financial institutions to exit the market promptly can

create moral hazard among market participants, jeopardizing the soundness


210

of the financial system. The System for Market-Based Resolution of Ailing

Financial Institutions is a method of eliminating causes of instability from

the market and increasing market soundness by making it easier to force trou-

bled institutions to exit.

Before the currency crisis, the belief that they were “too big to fail” pre-

vented banks in the Republic of Korea from being forced out of the market.

As a result, they did little to enhance their business soundness, and the gov-

ernment was lax in its efforts to build a healthy financial industry. Instead of

encouraging the exit of ailing financial institutions by allowing mergers, the

government tried to keep them in the market in the name of maintaining

order within the industry.

In December 1997 the Korean government greatly relaxed the regulation

on mergers of financial institutions by establishing the Financial Structure

Improvement Act. The legal foundation was also laid at that time for accel-

erating the resolution of insolvent institutions, by strengthening laws on clo-

sure of nonviable financial institutions and on loss-sharing and capital

reduction, by reviewing the bankruptcy law to find a way to accelerate the

bankruptcy process and by allowing mergers and acquisitions involving for-

eigners. When financial institutions had gone bankrupt in the past, it had

been hard to operate solely on the basis of market principles, as the highest

priority had been to protect the public interest. In the wake of the currency

crisis, however, a market-disciplined process for removing failed institutions

from the market was set up—by demanding that they maintain specified

Bank for International Settlements capital ratios, for example. In addition, a

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Table 2

Resolution of insolvent financial institutions

Ratio of resolved

Institutions institutionsInstitutions resolved (1998–2002) to total Newly Institutions

at end- License Dissolu- institutions opened at end-1997 revoked Mergers tions Total in 1997 institutions 2002

Banks 33 5 10 — 15 45.5 1 19Nonbanks 2,068 122 150 368 640 30.9 63 1,491Total 2,101 127 160 368 655 31.2 64 1,510

— Not available.Source: Public Fund Oversight Committee in Korea.

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.

Enhancing the transparency of financial institutionsTransparent public disclosure is critical for strengthening market discipline

and improving the soundness of the financial system. By providing the mar-

ket with important information on financial institutions’ management con-

ditions and inherent risks, such disclosure strengthens market discipline,

driven by shareholders, depositors and creditors, and encourages financial

institutions to focus on sound and responsible management.

The Republic of Korea did not have well developed public disclosure stan-

dards before the crisis. What disclosure requirements were in place fell short

of international standards, and waivers were granted to branches of foreign

banks, merchant banking corporations, mutual savings and finance compa-

nies and investment trust management companies.

Following the crisis the government implemented a number of measures

to tighten public disclosure standards and improve corporate governance at

financial institutions. In October 1998 it established the Financial Industry

Disclosure Standard, which improved management disclosure in several ways:

• The scope of institutions subject to disclosure requirements was

expanded to include all financial institutions—including the previ-

ously excluded branches of foreign banks, merchant banking corpo-

rations, mutual savings banks, finance companies and investment

trust management companies.

• Management disclosure was classified into two types—regular dis-

closure and ad hoc disclosure6—with regular disclosure required to

meet international accounting standards.7

• The frequency of regular disclosures was increased from once a year

to twice a year for companies and four times a year for banks. The


212

methods of disclosure were also diversified, to include disclosure over

the Internet.

• Restraints on false disclosures and those not made in full faith were

strengthened. A financial institution that discloses false information

or omits important information is required to correct it or to make

a new disclosure. If appropriate, it can be subject to legal action.

• To improve confidence in management disclosure, outside auditing

of financial statements was made mandatory. Closing financial state-

ments are now subject to full audit, and half-yearly provisional finan-

cial statements are subject to review.

If public disclosure by financial institutions is to be useful, financial state-

ments need to be reliable. The accounting system has therefore been improved

to meet international standards. The Republic of Korea introduced the mark-

to-market system in November 1998 and changed the basis for evaluating

securities held by financial institutions from book value to market value.8 The

requirements for loan loss and securities valuation loss provisions were also

changed, from partial provisioning to 100 percent provisioning, in accordance

with international standards.

Corporate governance at financial institutions has also been strength-

ened, in order to enhance managerial transparency. Since January 1997 banks

have been required to appoint more than half of their directors from outside

their organizations.9 As this outside director system alone seemed insufficient

for checking the influence of powerful management, since January 2000 banks

have been required to set up audit committees, two-thirds of whose members

must be outside directors. Banks were also required to set up basic rules and

internal standards for protecting their investors, and stricter observance of

laws and regulations was demanded of bank managers and employees in per-

forming their duties. At the same time, it was stipulated that a compliance

officer must be appointed at each bank, to report to the bank’s audit committee

about rules or internal standards that were violated.

Setting up a prudential supervisory system Financial globalization has exposed the Korean financial market to external

shocks, such as large unanticipated swings in foreign capital flows. In response

to these increasing risks, the Korean government has turned away from its past

focus on business operation and price regulation and started to focus on pru-

dential regulation in order to manage financial institution risk. Bank for

International Settlements capital ratio requirements have been tightened, the

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213

asset soundness classification criteria strengthened to follow international stan-

dards and prompt corrective action introduced into the regular system for

supervising financial institutions.

Strengthening prudential supervisionTo facilitate the efficient supervision and regulation of financial institutions,

prudential supervision has been tightened. In accordance with its agreement

with the IMF in December 1997, the Korean government strengthened Bank for

International Settlements capital ratio requirements to promote the soundness

of financial institutions.10 In 1998 financial institutions with Bank for Interna-

tional Settlements (BIS) capital ratios lower than 8 percent were required to

improve their financial structures. In January 1999 the method for calculating

this capital ratio was changed to meet international standards (loan loss provi-

sions for nonperforming assets are now deducted from tier 2 capital, for exam-

ple, and securities held by financial institutions are evaluated at market value).

In December 1999 forward-looking criteria were introduced for evaluat-

ing the levels of credit risk to which financial institutions could be exposed in

managing their assets. The move was intended to enhance institutions’ sound-

ness by helping prevent their loans from turning sour. In addition to the details

of borrowers’ past financial transactions—the only concern of previous asset

classification practices—forward-looking criteria also consider their future

debt repayment capacities. Accordingly, financial institutions now evaluate

their asset holdings in three areas—the borrower’s debt repayment capacity,

the degree of solvency and compliance with the payment schedule—and clas-

sify asset soundness in each area according to five grades: normal, precau-

tionary, substandard, doubtful and estimated loss. The lowest of the three

grades becomes the final soundness level for each asset. The requirements for

loan loss provisions have also been tightened based on these classifications.

Financial institutions must set aside 0.5 percent of normal assets, 2 percent of

precautionary assets, 20 percent of substandard assets, 50 percent of doubt-

ful assets and 100 percent of estimated loss assets as provisions against loan

loss. In addition, they must maintain their own independent credit review

systems, in order to enhance the accuracy and objectivity of their classifica-

tions of asset soundness and their accumulations of loan loss provisions.

In April 1998 the Korean government enacted the Financial Industry

Restructuring Act and introduced a prompt corrective action system, aimed

at instituting regular supervision of financial institutions and thereby pre-

venting their insolvency. The prompt corrective action system bolsters the


214

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).

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215

Table 3

Prompt corrective action taken in response to problem banks

Management Management Management Enforcement improvement improvement improvementcriterion recommendation requirement order

Bank for Less than Less than Less than International 8 percent. 6 percent. 2 percent.Settlementsratio

Management Third or higher grade Fourth or lower —status overall and below overall grade.evaluation fourth grade in

asset quality or capital adequacy.

Management Organizational changes, Control of deposit Capital write-down, improvement specific allowances, interest rate, suspension of top action restrictions on entry replacement of management, merger

into new areas and senior or consolidation new investment, management with other reduction or increase and external financial institutions, of capital, disposal of auditors, revocation of nonperforming loans. suspension from business license.

some business areas, dissolution.

Enforcement Management Management Financial criteria for improvement improvement Supervisory management requirement is order is issued if System forces improvement issued if bank bank fails to fully bank to exit if itaction fails to fully comply with action. fails to fully

comply with comply with action. action.

Source: Financial Supervisory System.

Before introduction of the system, Korean supervisory authorities used a

management improvement guidance system to supervise financial institu-

tions. That system was ineffective, because decisions as to whether or not to

take corrective action were left to the authorities and the actions they could

take excluded such powerful options as canceling business permits and order-

ing management changes. Under the prompt corrective action system, action

is now automatically triggered under clear and objective criteria relevant to

management conditions at financial institutions, freeing the process from

dependence on the authorities’ discretion. The criteria used are the Bank for

International Settlements ratios and the capital adequacy, asset quality, man-

agement, soundness, earnings and profitability, liquidity and sensitivity to

market risk (CAMELS) evaluation system results for banks and merchant

banking corporations, net operating capital ratios for securities firms and sol-

vency margin ratios for insurance companies.11 As recommended by the Bank

for International Settlements and the IMF, the scope of the prompt corrective

action framework embraces almost all financial institutions.

Improving the deposit insurance systemA deposit insurance system helps maintain financial stability by preventing

bank runs. It can also hamper stability in the financial industry, however, when

it encourages financial institutions to take on too much risk, and it creates

moral hazard in the market by weakening depositor-driven discipline. Under

a deposit insurance system, discipline can be weakened because depositors

and creditors have less incentive to monitor the risk-taking of financial insti-

tutions, knowing that their deposits or claims are safely protected even if these

institutions go bankrupt.

The Republic of Korea’s deposit insurance system, first introduced for banks

in 1995, was a partial insurance system. Right after the 1997 currency crisis

unfolded, it was changed to a blanket deposit guarantee system to help prevent

bank runs and resolve ailing financial institutions.12 This system was maintained

as a temporary measure until 2000. In addition, its coverage was expanded to

include deposits with securities firms, insurance companies, merchant banking

corporations, mutual savings companies, finance companies and credit unions.

These changes were effective in stabilizing the financial market, but at the

same time they led to moral hazard (financial institutions pursuing high

risk–high yield strategies, depositors seeking out unreasonably high interest

rates). It was therefore inevitable that the government would revise the enforce-

ment decree, as it did in July 1998, to reduce the scope of the financial


216

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

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Table 4

Deposit guarantee coverage in major countries, 1999

Country Ratio of deposit coverage to per capita GDP (percent)

Republic of Korea (2002) 4.0United States 3.2Canada 2.1Germany 0.8United Kingdom 1.4European average 1.6World average 3.0

Source: Garcia 1999.

ACHIEVEMENTS IN STRENGTHENING THE FINANCIAL SYSTEM

Korea has improved the soundness of its financial system, with more trans-

parent accounting and stronger prudential supervision, improving the effi-

ciency of its financial system and accelerating economic growth.

Effects on the soundness of financial institutionsA financial system can remain sound only as long as most financial institu-

tions in it are solvent and are expected to remain so, with assets exceeding lia-

bilities (Lindgren and others 1996). The soundness of a financial institution is

believed to be determined by the adequacy of its short-term capital, the sound-

ness of its asset, its profitability and its management capability.

How have the series of institution-building efforts in Korea’s financial

sector affected performance? A series of measures to boost prudential super-

vision, such as tightening Bank for International Settlements capital adequacy

ratio requirements; the introduction of the prompt corrective action system

in April 1998; and the introduction of forward-looking criteria in December

1999 made significant contributions to improving the capital adequacy, asset

soundness and profitability of Korean banks, which in turn greatly boosted the

overall soundness of the financial industry.

As of the end of 1997, the average Bank for International Settlements cap-

ital adequacy ratio of Korean banks was 7.04 percent (table 6). This figure

increased to more than 10 percent in late 1999, reaching 10.52 percent at the

end of 2002. This improvement can be attributed to the strong requirement


218

Table 5

Source of the Deposit Insurance Fund, 1998–2002 (billion won)

Accumulated Ratio to1998 1999 2000 2001 2002 amount total

Contributions remitted 2 21 329 27 13 841 0.1

Premiums 2,343 4,161 5,404 7,848 8,778 33,915 2.6Issuance of

bonds 210,150 224,850 89,407 310,593 36,600 871,600 67.6Borrowing 16,293 52,140 129,574 49,680 59,553 383,251 29.7

(repaid) (9,337) (33,870) (9,802) (110,196) (3) (163,208)Total 228,788 281,172 224,714 368,148 104,944 1,289,607

Source: Korea Deposit Insurance Corporation 2002.

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).

Effects on economic growthHaving a sound financial system with more transparent accounting and

strengthened prudential supervision reduces information asymmetries

between creditors and borrowers, which improves financial system efficiency.

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219

Table 6

Capital adequacy ratio at commercial banks in the Republic ofKorea, 1995–2002 (end of year)

Year Bank for International Settlements capital adequacy ratio (percent)

1995 9.331996 9.141997 7.041998 8.231999 10.832000 10.532001 10.812002 10.52


Traditional theory concerning the relationship between financial industry

development and economic growth suggests that financial industry growth or

increased financial system efficiency reduces transactions costs, allows better


220

Table 7

Indicators of soundness of assets of commercial banks in theRepublic of Korea, 1996–2002 (hundred billion won)

End of year 1996 1997 1998 1999 2000 2001 2002

Total loans 2,896 3,758 2,885 3,283 3,616 3,791 4,646Nonperforming loans — — — 274 239 110 90Loans overdue for three

months or more — — — 61 38 25 44Nonaccrual loans — — — 213 201 85 46Nonperforming loans/

total loans (percent) — — — 8.3 6.6 2.9 1.9Loans classified as

substandard and below 119 227 212 446 320 126 113Substandard 94 126 112 282 150 65 64Doubtful 20 96 91 124 143 48 36Estimated loss 5 5 9 41 27 13 12Substandard and below

loans/total loans (percent) 4.1 6.0 7.4 13.6 8.8 3.3 2.4

— Not available.Source: Financial Supervisory System.

Table 8

Return on assets and return on equity of commercial banks in theRepublic of Korea, 1996–2002 (percent)

Year Return on assets Return on equity

1996 0.26 3.801997 –0.93 –14.181998 –3.25 –52.531999 –1.31 –23.132000 –0.57 –11.902001 0.76 15.882002 0.59 11.67


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.

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221

THE OUTLO OK FOR FURTHER IMPROVEMENT OF THE REPUBLIC OF

KOREA’S FINANCIAL SYSTEM

Since the late 1980s the Republic of Korea has pushed forward with financial

and capital liberalization. Its efforts have led to the expansion of international

current and capital account transactions, opening the era of financial global-

ization. The 1997 currency crisis taught the country two valuable lessons about

the potential dangers of financial globalization. First, having an unsound finan-

cial system can lead to a currency crisis. Second, in order to reduce the nega-

tive effects of financial globalization, it is imperative to set up a sound financial

system in accordance with international standards. Based on these lessons, the

Korean government earnestly embarked on financial institution building aimed

at enhancing financial soundness. It created the environment for stable macro-

economic operations, established a system for market-based resolution of ail-

ing financial institutions, enhanced financial institutions’ transparency, set up

a prudential supervisory system and improved the deposit insurance system.

Additional efforts to improve financial institutions are under way and

will be carried out on an ongoing basis in the future as well. Future institution-

building efforts are expected to focus on strengthening market discipline and


222

Table 9

Results of causality test between financial development andeconomic growth (F-statistics)

QuarterNull hypothesis 1 2 3 4 5 6 7 8

Before institution-building: First quarter 1990–third quarter 1997∆GDP | ∆FIN 0.86 0.44 0.33 0.24 0.34 0.18 0.82 0.55∆FIN | ∆GDP 0.48 0.40 0.25 0.24 0.27 0.25 0.98 0.44 Entire period: First quarter 1990–fourth quarter 2003∆GDP | ∆FIN 1.52 1.06 1.13 1.59 2.88*** 1.97** 1.64 1.41∆FIN | ∆GDP 7.22*** 4.10*** 2.86*** 2.05** 1.61 1.12 0.96 0.93

*** Null hypothesis rejected at the 1 percent significance level. ** Null hypothesis rejected at the 5 percent significance level.* Null hypothesis rejected at the 10 percent significance level.Note: Granger causality test model: ∆FINt = α0 + Σα1i ∆FINt–i + Σα2i ∆GDPt–i + εt, and

∆GDPt = β0 + Σβ1i ∆GDPt–i + Σβ2i ∆FINt–i + Ut, where ∆FIN indicates the first dif-ference of financial development and ∆GDP indicates the first difference of the eco-nomic growth variable.

enhancing transparency in such areas as monetary and fiscal policy, financial

supervision, accounting and audit systems and the deposit insurance system,

in accordance with global standards and codes. The following are areas in

which measures are now being taken or will be taken in the near future:

• The Bank of Korea Act was revised in August 2003, following its revi-

sion in 1997. The revised act went into force in January 2004. Under

its provisions the deputy governor of the Bank of Korea sits on the

Monetary Policy Committee as an ex officio member. The change

means that monetary policy can be implemented with greater reference

to the market, in a more market-friendly manner. The revised act also

gives the Bank of Korea greater autonomy over its budget for imple-

menting monetary policy.At the same time, to improve monetary pol-

icy efficiency, the inflation targeting framework was changed so that it

uses an intermediate target rather than an annual one. This change

enables the central bank to exercise intermediate policies better, in con-

sideration of the time lag between monetary policy and its effects.

• To enhance fiscal soundness, the government intends to set up a three-

year mid-term fiscal plan, with regular reporting to the National

Assembly. It also plans to tighten the requirements for supplementary

budgets, except under certain extraordinary circumstances.24

• The Financial Supervisory Service plans to introduce a risk-based

supervision system. Risk-based supervision involves the regular

evaluation of the levels of risks institutions face and of their man-

agement capacity for dealing with these risks. It is a preemptive super-

vision system, because it allows the authority to identify early warning

signals at financial institutions with too much risk and to then focus

on these high-risk business operations. In preparing for this system,

the Financial Supervisory Service, working jointly with financial insti-

tutions, has developed indicators for evaluating the risks involved in

institutions’ operating activities in each business area as well as indi-

cators of their risk management. The Financial Supervisory Service

completed its development of a risk management information system

and an evaluation program at the end of 2003 and plans to test them

in banks in the near future.

• Since the currency crisis, the government has made continuous efforts

to enhance transparency in corporate accounting practices. These

efforts are not yet satisfactory, however. In order to further improve

accounting practices, the government plans to implement several new

REPUBLIC OF KOREA

223

measures in the near future. These measures should make the

accounting and audit systems more transparent and effective. To

strengthen corporate accountability, the government will require

chief executive officers to certify the accounting information of their

companies, and companies disclosing false information will be held

legally responsible. To enhance the accuracy of internal auditing of

accounting information, companies’ audit committees will be

required to include financial or accounting experts.

• In the long run, risk-adjusted deposit insurance premiums are

expected to be introduced. The Korea Deposit Insurance Corporation,

the Financial Supervisory Service, the financial institutions and other

agencies concerned all agree on the need for a sounder incentive sys-

tem in the financial system, although they have not yet agreed on some

details, such as whether to give supervisory authority over financial

institutions to the Korea Deposit Insurance Corporation.

NOTES

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 currencycrisis or other panic may occur, because other investors also decide wrongly(Calvo and Mendoza 1998). “Momentum trading” may be thought of as a typeof herding behavior. In momentum trading, investors who lack informationregard an upward price trend as a signal that leading investors recognize an assetas 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 financialsystem in advance of complete capital liberalization as follows: revising the finan-cial legal framework, improving accounting and statistics, strengthening systemicliquidity arrangements and related monetary and exchange operations, strength-ening prudential regulation, restructuring the financial and corporate sectors anddeveloping capital markets.

3. The Framework Act on Public Funds Management, which seeks to heightenfiscal 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 theday was set by computing the previous day’s transaction volume–weighted averageof the Korean won’s rate against the dollar in the interbank market. Transactionswere made within a limited range of fluctuation around the target rate.

5. The daily range of fluctuation was widened seven times between 3 March1990 and 20 November 1997.


224

6. Regular disclosure must cover matters that have an important bearing ona company’s management, including its organization and workforce, financialaffairs and profit and loss; sources and uses of funds; business performance indi-cators, such as those concerning the company’s soundness; profitability and pro-ductivity; and management policy and risk management. Banks are also requiredto promptly disclose relevant details on nonperforming loans and financial inci-dents; the receipt of a management improvement recommendation, demand ororder; and other incidents, as determined by the governor of the FinancialSupervisory Service.

7. In addition to the 55 items that banks were previously required to disclose,such as their management performance and financial situation, they must nowdisclose 9 new items, covering such information as the size of their nonperform-ing loans, their credit rating, off–balance sheet transactions involving loans tosubsidiaries and large derivatives-related losses and the foreign currency liquid-ity ratio.

8. This system was first applied to all bonds included in funds launched after5 November 1998. Since 1 July 2000, it has been applied across the board.

9. When the system was first introduced, the term nonstanding director wasused. The term was changed to outside director in December 1999, with revisionof the Banking Act.

10. In December 1997 the Korean government agreed with the IMF to makeit mandatory for Korean banks to achieve a minimum 8 percent capital ratio, inaccordance with the Bank for International Settlements’ Core Principles forEffective Banking Supervision.

11. This system was introduced in the Republic of Korea in October 1996,with the aim of ensuring objective and reasonable assessment of financial insti-tutions’ management conditions. Under this system, financial institutions areevaluated in a comprehensive and unified method, in areas such as their man-agement capabilities, observance of legal regulations and financial conditions.Initially, banks were evaluated on the four main components of their financialpositions: capital adequacy, asset quality, management, earnings and liquidity.Later, sensitivity to market risk was added, in reflection of the importance of riskmanagement. For foreign bank branches, in contrast, the ROCA ratings methodis used, which evaluates the four components of risk management, operationalcontrols, compliance and asset quality.

12. This measure helped prevent subsequent bank runs on sound banks ormerchant banking corporations, limiting runs to individual unhealthy financialinstitutions. Thus from the third quarter of 1998, deposits at banks and mer-chant banking corporations recovered from their declining trend of the previ-ous quarter, which had been caused by the market exit of 5 banks and 16merchant banking corporations in the second quarter of 1998. Meanwhile,funds from money trusts, which were excluded from deposit guarantee coverage,

REPUBLIC OF KOREA

225

migrated on a very large scale into fixed deposit accounts at banks or beneficiarycertificates at investment trust management companies.

Deposits at selected financial institutions, 1997–98 (billion won)

1997 19981st 2nd 3rd 4th

Total quarter quarter quarter quarterBanks 291,505 327,565 102,434 34,094 116,503 74,534Money trusts 201,277 –391,678 –93,795 –88,923 –176,932 –32,029Merchant banking

corporations 35,822 –440,025 –363,243 –124,342 18,050 29,510

Source: Korea Deposit Insurance Corporation.

13. Repurchase agreements were excluded from protection, because deposi-tors can get back their principal from the bond issuers even if the bond-issuinginstitutions go bankrupt.

14. Current premiums are 0.1 percent for banks, 0.2 percent for securitiesfirms and 0.3 percent for other financial institutions, including insurance com-panies and merchant banking corporations.

15. This came about because the deposit guarantee system was introducedbefore sufficient funds had been raised. As a result, deposit insurance fund bonds,guaranteed by the government, had to be issued.

16. The ratio of loans classified as substandard and below to total loans rosesharply, to 13.6 percent in 1999, because of the introduction of forward-lookingcriteria, a more stringent standard for evaluating loan quality.

17. This “supply-leading view,” espoused by McKinnon (1973), Shaw (1973),and Goldsmith (1969), is supported by many empirical studies, including thoseby Bencivenga and Smith (1991) and Greenwood and Jovanovic (1990).

18. This “demand-following view,” espoused by Robinson (1952), is sup-ported by the empirical studies of Demetriades and Hussein (1996) and others.

19. This study used time-series data from 16 countries to analyze the rela-tionship between financial industry development and economic growth. Theratios of cash to monetary aggregates M1 and of M2 to GDP were used as proxyvariables for financial development.

20. Khan (2000) uses the same proxy.

21. Since the results of a unit-root test showed that all these variables arenonstationary, the first differences were used in the model.

22. Despite the desirability of comparing two separate time periods before andafter the crisis to determine the impact that postcrisis institution building had on


226

economic growth, the entire 1990–2002 period was used for estimation, as theperiod 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 aneed for government budgetary spending arises after the budget has been set.

REFERENCES

Al-Yousif, Y.K. 2002. “Financial Development and Economic Growth: AnotherLook at the Evidence from Developing Countries.” Review of FinancialEconomics 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 andthe Globalization of Securities Markets.” Working Paper 97-26. DukeUniversity, 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 CauseEconomic Growth? Time-Series Evidence from 16 Countries.” Journal ofDevelopment 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, andthe 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 Republicof Korea Following the Financial Crises: A Comprehensive Report.” KoreaInstitute for International Economic Policy, Seoul.

IMF (International Monetary Fund). 2002. “Capital Account Liberalization andFinancial 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.

REPUBLIC OF KOREA

227

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 ofFinancial 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 Jumpsbetween 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: OxfordUniversity Press.

Zang, H.S., and Y.J. Wang. 1998. “Adjustment Reforms in Korea Following theFinancial Crises: A Comprehensive Report.” Korea Institute for InternationalEconomic Policy, Seoul.


228

MEXICOInstitutions—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.

PROTECTED FINANCIAL MARKETS (FIRST PHASE: 1970–88)Some of the foundations of the financial liberalization after late 1988 were

laid by institutional reforms undertaken since the mid-1970s. The most sig-

nificant were the transition from specialized to universal banking, the mod-

ernization of the securities market and the creation of a domestic public debt

market.

In the early 1970s interest rates were regulated, and the financial system

was integrated by specialized institutions subject to a variety of compulsory

credit allocation requirements, each with a maximum interest rate. This com-

plex system became unmanageable by 1974, when deposit rates had to be

increased sharply in response to adverse international conditions and domes-

tic inflation. Pressures on a far too rigid arrangement increased, and it became

necessary to remove regulations on lending rates gradually.

The Law on Credit Institutions was amended in 1974 to allow for

multiple-service or universal banks. Until then, the law provided only for

banks specializing in different types of services. The new multiple-service

banks could then attract deposits through various instruments, channel them

into different economic activities more flexibly than in the past and benefit

from economies of scale and risk diversification. The trend in international

financial markets away from bank credit and into securities also influenced the

development of the financial system. In 1975 a Securities Market Act estab-

lished the legal framework for the expansion of securities operations.

229

To alleviate the problems resulting from an extremely complex reserve

requirement system, a single reserve requirement ratio was adopted in 1977

for the liabilities in domestic currency of institutions operating as multiple ser-

vice banks. The introduction of Treasury certificates (CETES) in 1978 com-

plemented the measures on legal reserve requirements and interest rates. This

was to prove a watershed in Mexico’s financial development, because it led to

the growth of an active money market where interest rates would be increas-

ingly determined by market forces.1

These liberalization efforts were interrupted abruptly when commercial

banks were nationalized and exchange controls were introduced in September

1982 at the height of Mexico’s debt crisis.

Financial repression during this stage had a major impact on resource

allocation. Three indicators are worth noting:

• Financial savings—proxied by the ratio of the broadest monetary

aggregate in Mexico (M4) to gross domestic product (GDP)—

declined from 34 percent in 1970 to 30.9 percent in 1988.

• Real interest rates in Mexico were negative in the 1970s and showed

wide fluctuations in the 1980s, from highly negative to highly positive.

• As a result of the growing fiscal deficit, the public sector crowded out

private borrowing. Commercial bank financing to the private sector

fell from 18 percent of GDP in 1970 to less than 13 percent in 1987.

Financial repression affected resource allocation through additional chan-

nels. High reserve requirements and credit controls increased substantially

the costs of intermediation, eroded banks’ competitiveness and channeled an

important amount of resources to nonprofitable activities. In addition,

restricted bank financing to the private sector, coupled with low real interest

rates for bank deposits, caused considerable expansion of an already large

informal credit market. Since operations in this market were often conducted

without proper records, its expansion threatened to introduce an element of

instability into the economy.

FORTIFYING FINANCIAL INSTITUTIONS

(SECOND PHASE: 1988–94)A major move toward financial liberalization was launched in November 1988,

as part of a stabilization and structural reform program and in view of the high

costs resulting from financial repression. Deregulation, internationalization

and bank privatization were the three main aspects of the process. These

measures sought to promote the development of the Mexican financial system


230

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.

Deregulation of the financial sectorThe main measures adopted in late 1988 were the following. First, multiple ser-

vice banking institutions were permitted to place bankers’ acceptances without

any limit (the instruments’ yields and maturities were determined according to

market conditions). Second, banks were allowed to invest freely from these

sources, subject to the restriction of maintaining a liquidity ratio of 30 percent

in the form of certain government debt instruments and interest-bearing deposits

at Banco de México. Third, banks were authorized to participate in CETES auc-

tions, bidding either on their own account or on behalf of third parties.

In April 1989 selective credit controls were abolished, reserve require-

ments on bank deposits were substituted by a new 30 percent liquidity coef-

ficient similar to that applicable to bankers’ acceptances and mandatory

lending at below-market interest rates to the public sector by commercial

banks was discontinued. In September 1991 the authorities eliminated the 30

percent liquidity coefficient imposed on banks. In the same year, foreign

exchange controls in force since 1982 were removed.

Internationalization of the financial sectorInstitutional reforms in the financial system in the late 1980s were also fos-

tered by modifications to the legal framework. The reforms approved by

Congress in 1989 permitted foreign investors to hold a minority share in the

capital of financial intermediaries for the first time in 50 years. In addition, the

government allowed foreigners to undertake portfolio investment in Mexican

equities through special 30-year trust funds. At the end of 1990 the restrictions

on nonresident purchases of fixed-income securities, especially government

securities, were abolished. With the last two measures, the capital account of

the balance of payments was fully opened to portfolio foreign investment. This

played a significant role in the surge in capital inflows from 1990 to 1993.

The privatization of commercial banksIn 1990 the Mexican Political Constitution was amended, eliminating the gov-

ernment’s exclusive right to provide banking and credit services. As part of the

bank privatization, long-standing restrictions on foreign investment in the finan-

cial sector were liberalized. As a result, foreign investment of up to 30 percent of

MEXICO

231

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.

Autonomy of the central bankThe main driving force that led to central bank autonomy was the desire to

signal to markets the government’s commitment to price stability in a

medium-term context.2 With the constitutional mandate to the central bank

to achieve price stability, attaining low and stable inflation became an insti-

tutional feature of the monetary policy framework. Policy based on individ-

uals became policy anchored on institutions. This institutional change

acknowledged that Mexico’s acute and prolonged inflationary process was

closely linked to the financing of large fiscal deficits by the central bank. With

autonomy, the government would no longer be able to finance its deficit with

credit from the central bank. This was an implicit guarantee that the decade-

long efforts to bring public finances under control were permanent.

The role of the North American Free Trade AgreementThe signing of the North American Free Trade Agreement (NAFTA) in 1993

represents one of the most important institutional changes in Mexico in recent

years. NAFTA provided an additional major impulse to opening the financial

sector to foreign investment. On 23 December 1993, to respond to the com-

mitments assumed under NAFTA, the Mexican Congress approved new amend-

ments to financial legislation allowing foreign financial institutions, based in a

country with which Mexico has signed an international agreement, to establish

fully owned subsidiaries in Mexican territory.

The opening of the financial sector under NAFTA sought to maintain a

balance between the objective of promoting competition in the sector and

ensuring not to jeopardize the stability of financial intermediaries and the

economic stabilization program. In this context, the NAFTA provisions would

be phased in gradually, with interim individual and aggregate limits on the

market share of U.S.- or Canada-based banks, brokerage houses and insurance

companies. These limitations were relaxed in the context of the financial lib-

eralization during 1995–2003.

Impact on the economyThe results of the liberalization of the financial sector, and especially the open-

ing of the capital account in a context of booming confidence in the early


232

1990s, led to a surge in capital inflows, which reached an average of nearly 8

percent of GDP during 1991–93. Financial liberalization and capital inflows

increased the availability of credit. And as a result of the strengthening of pub-

lic finances, the borrowing requirements of the public sector fell, freeing more

financial resources for the private sector. These developments coincided with

a strong demand for credit, and bank financing to the private sector posted

an impressive growth. Its share in GDP increased fourfold between 1988 and

1994 (from 10.8 percent to 42.9 percent).

Unfortunately, bank credit increased at a time when supervision by the

financial authorities was inadequate, and before banks could establish the

internal controls to ensure that credit would be granted prudently (Ortiz

1998). Furthermore, as a consequence of the unlimited backing of banking lia-

bilities, moral hazard increased. The situation was complicated by the emer-

gence of important macroeconomic disequilibria: a significant appreciation

of the peso in real terms, a sharp decline in private savings and a large current

account deficit.

The weaknesses that accompanied the growth in bank credit and the decline

in private saving set the stage for a major economic and banking crisis. The cri-

sis was a result of many factors, external and domestic, economic and political.

Although the measures of financial liberalization introduced since the late 1980s

played an important role, the fundamental problem was not liberalization itself.

The problem was the absence of conditions required to ensure its success: a sta-

ble macroeconomic environment, an adequate timing and sequencing of

domestic and capital account liberalization, a financially sound banking sys-

tem, adequate mechanisms of bank supervision, and efficient and experienced

management at the front of financial institutions. Moreover, deposit guarantees

gave rise to serious moral hazards (Mancera 1996, 1997b; Gil Díaz 1998).

REVAMPING THE FINANCIAL SECTOR IN THE AFTERMATH OF

THE CRISIS ( THIRD PHASE: 1995–2000)Despite the severe balance of payments and financial crisis of 1994–95 and its

devastating effects on the banking system, the financial liberalization contin-

ued. This result stems, to a significant extent, from a recognition of the ben-

efits of liberalization and the fact that the process of institution building made

it extremely difficult to reverse the liberalization of the financial sector in the

late 1980s and early 1990s. Efforts during this stage focused on measures to

overcome the banking crisis and on setting the conditions for healthy devel-

opment of an even more open financial system.

MEXICO

233

Macroeconomic stabilization 1995–96Mexico launched a comprehensive stabilization program in 1995, cutting pub-

lic expenditure, tightening monetary policy and adopting a flexible exchange

rate. In addition, the authorities were confronted with the need to manage the

threat of a systemic banking crisis. As a result, implementing a far-reaching

institutional reform of the financial system became a policy priority.

The macroeconomic setting: monetary and fiscal policiesMonetary policy. With the adoption of the floating exchange rate regime fol-

lowing the balance of payments crisis in 1994–95, monetary policy became the

nominal anchor of the economy. The challenge for the autonomous central

bank was to reduce inflation, which had skyrocketed in 1995 in the aftermath

of the devaluation of the peso, and to confront the credibility crisis.

In 1995 the central bank adopted a gradual disinflation process. In the

early stages after the crisis, it targeted the path of base money, but it then grad-

ually shifted to monetary conditions consistent with the inflation objective. A

formal inflation targeting framework was introduced in 2001.3

The implementation of monetary policy in the context of a strong insti-

tutional setting and supported by a prudent fiscal policy has proved very suc-

cessful in reducing inflation. The annual rate of growth of the consumer price

index fell from 52 percent in December 1995 to 5.4 percent in October 2004.

Core inflation has followed a similar trend.

Fiscal policy. The tightening of fiscal policy was one of the pillars of the

successful stabilization of the economy. But efforts in public finance extended

beyond this. In particular, given the importance of prudent and efficient man-

agement of fiscal policy, several institutional adjustments aimed at achieving

these objectives in the long term. The efforts of institutional reform in the

area of public finances have included the introduction of a longer-term

approach to public spending through three different channels:

• Developing a multiannual perspective consistent with public debt

sustainability in the medium term.

• Limiting the financing of current expenditures with public debt.

• Guaranteeing the financing of new programs or the expansion of

existing ones with stable sources.

Mexico has also strengthened the institutional framework for public

finances by including fiscal responsibility principles in the budget, to help

ensure that the approved expenditure ceilings and deficit targets are met. For

example, in addition to establishing ceilings on global expenditure and net


234

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.

Strengthening the financial systemEfforts in the financial sector after the crisis concentrated in two areas:

• Safeguarding the integrity of the financial system. This objective was

met satisfactorily, since systemic risk in the financial system was elim-

inated, and the fiscal cost of the schemes introduced to support

debtors and the banking system was limited and distributed over

many years.

• Setting in motion the policies to ensure the adequate functioning of

the financial system in an increasingly liberalized environment.

Several measures have been introduced since the late 1990s to accomplish

the second objective. In December 1998 Congress approved an ambitious

package of financial reform. Three items stand out from this package. First,

the gradual and orderly lifting of the blanket coverage of bank deposits, an

important source of moral hazard in the financial system, was begun. Second,

a new institute was created, the Institute for Bank Deposit Insurance, which

became operational in June 1999 to manage the new deposit insurance scheme

and the restructuring programs for banks that have received its support, and

to administer and sell assets acquired through several banking-support pro-

grams. Third, barriers to foreign ownership in the financial system were eased

further, so that foreign investment of up to 100 percent of common stock was

permitted in Mexican commercial banks and financial holding companies.

The supervisory and regulatory frameworks were also strengthened.

Accounting standards and rules were adjusted to conform to best interna-

tional practices, and stricter capital adequacy requirements were introduced.

Two additional measures were undertaken in this period. First, in April

2000 Congress approved bankruptcy and secured lending legislation. These

reforms were considered fundamental, since the deficient legal framework in

these areas had been an important obstacle to the resumption of lending to the

MEXICO

235

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).

Impact on the financial sectorThe reforms from 1995–2000 strengthened the financial sector and improved

the working of financial markets.

• The strategy strengthened banks’ financial conditions. The capitaliza-

tion index stood at 13.8 percent in 2000, almost twice its annual aver-

age in 1992–95 (it rose to nearly 14 percent in June 2004). Total loan

loss provisions as a share of past due loans, rose from 63 percent in

1997 to 115 percent in 2000 and to 174.5 percent in June 2004.

• A greater efficiency was achieved in the banking system, as reflected in

the narrower spread between lending and deposit rates. Expressed in

real terms, the spread of 5.2 percentage points in 1996–2000 (2.5 per-

centage points in October 2004) was down from 7.2 percentage points

in 1979–88.

• Foreign participation in the domestic banking system rose substantially

after the liberalization measures introduced in 1999, from 20 percent

of bank assets in that year to 52 percent in 2000 and to almost 82 per-

cent in June 2004. This promoted competition and was a fundamen-

tal element for the capitalization of the banking system.

Notwithstanding these important achievements major problems remained

in several areas. Two of these are particularly worth noting. First, despite the

improved financial situation of banks, the enhanced efficiency of the banking

system and the measures implemented to strengthen the legal framework

within which banks operate, bank credit failed to recover. Total bank credit to

the private sector fell from 42.9 percent of GDP in 1994 to an annual average


236

of 24.3 percent in 1997–2000 (13.6 percent in 2003). Second, the long-standing

efforts of financial reform were unable to increase financial intermediation to

more adequate levels. The ratio of M4 (end of period) to GDP, after peaking

at 50.9 percent in 1994, fell to 44.5 percent in 2000, and after the reforms

adopted since 2001, reached 51.1 percent in June 2004.

RECENT INSTITUTIONAL REFORMS (FOURTH PHASE 2001–04)A major concern—due to the small size of the financial system and the strong

public sector demand for financial resources—is that an insufficient fraction

of the financing of investment is carried out through the financial system. In

this context, a prominent role was assigned to financial reform in the 2002–06

National Program for the Financing of Development (PRONAFIDE). The

general objectives of the reform are:

• To promote domestic savings, with emphasis on popular and long-

term savings.

• To accelerate the modernization of the financial system and facilitate

the reactivation of bank credit.

• To deepen domestic stock and debt markets.

• To modernize development banks.

• To modernize and consolidate the pension system.

To meet these objectives, Congress has approved or amended a number

of laws since 2001 in the following areas.

Commercial bankingAlthough 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:

MEXICO

237

• 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

Development banksThe 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.

Stock and debt marketsThe Mexican Stock Exchange has been affected by important structural prob-

lems, including a low number of firms controlled by a few owners, and a

small investor base, both at the institutional and the retail levels. The domes-

tic debt market is dominated by public sector instruments, with private issues

MEXICO

239

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.

InsuranceThe 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 systemThe 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

With the amendments, complementary contributions for retirement can

be collected when the worker turns 60. The amendments also eliminate the

restriction on investing in foreign securities, allowing retirement savings fund

managers to invest up to 20 percent of their total assets in these instruments.

And they eliminate the restriction to invest in equities, allowing investments

in local and international equities through Principal Protected Notes linked

to the main international equity indexes (these changes to the investment

regime became operational in December 2004).

Payment systemBanco 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.

The role of international financial institutions in fostering institution buildingDuring the second half of the 1990s, international financial institutions began

to emphasize institution building in the financial sector. The International

Monetary Fund (IMF) and World Bank developed assessments to identify the

strengths and weaknesses of financial systems, and the Reports of the

Observance of Standards and Codes to evaluate the performance of a coun-

try in areas such as fiscal and monetary policies and financial supervision.

Mexico has benefited from the initiatives undertaken by international

financial institutions to promote institution building in the financial sector.

MEXICO

241


242

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.

LESSONS FROM THE MEXICAN EXPERIENCE

The institutional measures carried out in the Mexican financial system dur-

ing the period 1970–88 set the basis for the far reaching liberalization of the

sector that was begun at the end of this period. Since then, liberalization and

more generally globalization have been important catalytic forces behind

institution-building efforts. Simultaneously, the Mexican case has served to

illustrate the risks that may accompany globalization if it is not accompanied

by a sufficiently strong institutional setting.

Since the late 1980s, as the process of globalization was gaining momentum,

Mexico transformed radically its economic structure. It opened its economy to

world trade, redefined the role of the state in economic activity and embarked on

wide-ranging structural changes, including in the financial sector. During

1988–94, major institutional developments took place, including the opening of

MEXICO

the capital account of the balance of payments, the privatization of commercial

banks, the authorization of foreign investment in the banking system, the approval

by Congress of autonomy for the central bank and the signing of NAFTA.

The combination of these and other factors gave rise to a surge in capital

inflows and an explosion of credit that set the stage for an economic and bank-

ing crisis of major proportions that began in late 1994. Although the factors

that gave rise to the crisis are complex and varied, the lack of a sufficiently

strong institutional environment in the financial sector was clearly one of

them. Indeed, financial liberalization was accompanied by important institu-

tional weaknesses: inadequate supervision of banks, inexperienced manage-

ment at the helm of financial institutions and the presence of major moral

hazard problems in the banking system, among others.

In the aftermath of the 1994–95 crisis, the institutional measures introduced

during the previous years contributed to the authorized decision not to revert the

financial liberalization process. In fact, the decision was to deepen globalization

of the financial sector. In addition, in one of the major institutional changes of

the period, the pension system was transformed from a pay-as-you-go to a defined

contribution fully funded scheme. Moreover, the crisis raised public awareness of

the importance of maintaining prudent economic and financial policies and

developing and supporting institutions that limit the discretionary powers of the

authorities in these areas. In this context, monetary policy was reinforced and

fiscal rules were adopted to maintain a low fiscal deficit on a long-term basis.

Although the above measures resulted in a stronger and more efficient

financial system, a number of problems remained. Among them, a relatively

small financial sector and a banking system that has not supported adequately

economic activity through the provision of credit. In view of the above and

of other problems, the pace of reform of the financial system has accelerated

over the last four years, with efforts concentrated on establishing the institu-

tional framework needed for promoting financial savings, modernizing the

financial system, fostering the resumption of bank credit, deepening domes-

tic debt and stock markets, modernizing development banks and consolidat-

ing the pension system.

With the progress in institution building, the Mexican financial system is

poised to reach international standards for its effectiveness, security and

potential contribution to the development of the country. But this is an on-

going process, and there is still plenty of room for improvement. In particular,

additional efforts are needed to enhance the efficiency of the framework for

regulation and supervision, to create a new legal basis for bank resolution, to

243

review the banking system’s normative scheme and to implement the measures

needed, if any, to ensure a healthy growth of bank credit.

NOTES

1. In the last two and a half decades, the Mexican authorities have striven todevelop domestic debt markets. The initial steps date back to this first issue of gov-ernment peso-denominated fixed-rate securities. Initially, both the number ofmarket transactions and the amounts involved were small; securities had short-term maturities, no secondary market existed, and the government determinedinterest rates. But, over the years both the government and the central bankincreasingly relied on the debt market, the former to cover its financial needs andthe latter as an instrument of monetary policy.

2. In August 1993, Congress approved an amendment to Article 28 of theMexican Political Constitution granting autonomy to the central bank. The pri-mary objective of the autonomous central bank under the new Article 28 is to seekthe stability of the purchasing power of the national currency. In addition, Congresspassed 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 inflationobjective 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 consumerprice inflation), with intermediate targets of under 6.5 percent in 2001 (the observedinflation rate was 4.4 percent) and under 4.5 percent for 2002 (the observed inflationrate was 5.7 percent). In July 2002, Banco de México formally established the 2003inflation 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 revenuesare 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 OilStabilization Fund, plus interest earnings and other less importantsources.

• 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 ofthe items where these expenditure reductions will be carried out. Incase the previous adjustments are not enough to compensate for therevenue shortfall, the government will be entitled to adjust otherexpenditure items.

– If the reduction in revenues is larger than 5 percent of tax revenues,programmable expenditures will be reduced. In this case, Congresswill have to approve the specific items where the expenditure adjust-ments will take place.


244

• Extra revenues would be directed as follows:• 25 percent to the Oil Stabilization Fund.• 25 percent to strengthen the public sector balance.• 50 percent to promote infrastructure projects in federal entities.

5. Besides this individual account, the system has two additional subaccountsfor employees. One is the voluntary contribution, which allows the employee oremployer to deposit additional contributions, benefiting from an increase in theamount accumulated for retirement in addition to those required by law. And thesecond is the housing scheme, in which the employer’s contributions are regis-tered in the Administration for Retirement Funds and are destined to a housinginstitution named INFONAVIT, in conjunction with the interest rates that theinstitute pays.

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SAUDI ARABIASince 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.

THE GENESIS AND EARLY YEARS

The modern banking system in Saudi Arabia has its roots in the creation of

SAMA in October 1952. Before this, branches of a few foreign banks and some

local money changers provided all financial services to meet the needs of the

trading community and pilgrims. But by 1952 the inflow of the royalty rev-

enues from oil contributed to a sharp rise in government revenues and expen-

ditures. As this gave a boost to the domestic economy, demand for financial

services rose sharply. The government followed open and liberal policy that

encouraged a competitive banking environment and permitted the opening

of new domestic and foreign banks in Saudi Arabia.

SAMA’s creation was followed by the licensing of more foreign bank

branches, including Banque de Caire, Banque du Liban et d’Outre Mer and

First National City Bank of New York, in the first wave of foreign banks that

linked Saudi Arabia firmly with the global financial markets. Some domestic

banks were also licensed: the National Commercial Bank in 1953, Riyad Bank

in 1957 and Al Watany Bank in 1958.

Introduction of paper money. During the period 1950 to 1956, there was a

partial introduction of paper money in the form of Pilgrim Receipts, supported

by precious metals and foreign currencies. By 1960 the riyal was officially pegged

248

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.

CONSOLIDATION AND RESTRUCTURING IN THE 1970S

In the 1970s total assets of the commercial banks increased 35 times, from

$720 million to $24.8 billion, and deposits 42 times, from $426 million to

$18.1 billion. The demand for commercial credit lagged behind the new liquidity

because low-cost medium- to long-term credit was easily available from the

government lending institutions. The foreign assets of the commercial banks

grew rapidly from 19 percent of the total assets in 1972 to 44 percent in 1980.

Driven by the need of SAMA and the Saudi banks to place their excess liquid-

ity in the global market, significant relationships evolved between local and for-

eign banks. SAMA itself became an important player and in 1983 entered the

General Agreement to Borrow with the International Monetary Fund.

Money changers. In 1979, 9 of the 12 banks in operation were Saudi, and the

total number of bank branches had almost doubled to 140. But many cities and

SAUDI ARABIA

249

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.

BANKING PROBLEMS AND THEIR RESOLUTION IN THE 1980S

Significant gaps remained in the provision of banking and financial services:

unmet credit needs for small business, limited checking facilities, nonexistent

foreign currency transfers (still provided mostly by money changers), a lack

of consumer loans and facilities for small savers, antiquated banking methods,

nonexistent computer technology and a regionally based clearinghouse sys-

tem. Other deficiencies were the high dependence of banks on expatriate

workers and the lack of Saudi nationals in banking business.

Boom and bust in the early 1980s. With the tremendous increase in gov-

ernment revenues from 1979 to 1981 and the subsequent slowdown from 1982


250

to 1986, the country’s commercial banks saw rapid expansion followed by a

difficult adjustment and retrenchment.

The tumbling of oil prices from the all-time high in 1981 put significant

pressure on the quality of banks’ assets, which deteriorated with the economic

slowdown. Credit to the private sector, up 500 percent during 1976–81, grew

by only 20 percent during the next five years. Nonperforming loans rose to

more than 20 percent of all loans by 1986. Bank profits suffered as loan loss

provisions and writeoffs mounted. By 1988, however, most banks had made

sufficient provisions for doubtful accounts, and the average provision for the

banking system as a whole had risen to more than 12 percent of total loans.

Slowdown in economic activity. Falling oil prices also dampened real eco-

nomic activity. Government revenues, SR333 billion in 1981, dropped to just

SR74 billion by 1987. Many companies and businesses faced a credit crunch.

The construction and contracting sectors, which had boomed earlier, faced the

biggest setback. And banks had difficulties recovering their loans.

In 1982 irregularities appeared in Saudi Cairo Bank’s operations. Two

senior managers, involved in unauthorized trading in bullion during 1979–81,

had concealed accumulated losses that exceeded the bank’s share capital. SAMA

required the bank to issue new shares and double its capital in 1986, with the

increase to be taken up entirely by the Public Investment Fund. The bank also

benefited from low-cost deposits from the Public Investment Fund. These mea-

sures restored it back to a healthy position.

The government’s response. SAMA and the Ministry of Finance took steps

to ensure the stability of the financial system and to help the banks overcome

their problems:

• Banks were required to seek SAMA’s approval before announcing

their dividends. The Banking Control Law required all banks to build

statutory reserves equal to their share capital. SAMA also encouraged

the banks to build additional reserves and strengthen their capital

bases.

• Most foreign shareholders in Saudi banks enjoyed a tax holiday for

the first five years of their ownership. To encourage the retention of

profits, the tax holiday was extended in most cases by another five

years, after which a deferred tax scheme was permitted.

• In 1986 SAMA obtained a ruling from the Tax Department that per-

mitted a tax deduction of loan loss provisions on an accrual basis.

This encouraged banks to increase their loan loss provisions for

doubtful accounts.

SAUDI ARABIA

251

• To encourage Saudi banks to increase their interbank dealings and

support the development of a riyal interbank market, a tax ruling

exempted foreign banks from withholding taxes when carrying out

interbank transactions with Saudi banks.

• SAMA took steps to improve corporate governance. It required all

banks to develop and strengthen their internal audit departments

and issued minimum internal control guidelines. It also issued

accounting standards for commercial banks in line with international

accounting standards.

• In 1987 Saudi authorities established a Banking Dispute Committee as

the only relevant quasi-court to handle dispute between banks and their

customers, significantly strengthening the legal system. By law, all bank-

ing disputes had to be referred to this committee, and its rulings were

given the same enforcement support as decisions from any other court.

• In the early 1980s SAMA had established a credit information service

that provided information to Saudi banks on all large exposures of the

banking system. This made it easier for banks to assess the credit posi-

tion and risk of big borrowers. Also in 1986 SAMA permitted banks

to exchange information on delinquent borrowers and apply collec-

tive pressure. These measures have proved quite effective in resolving

problems of delinquent loans.

Mergers and restructuring. The United Saudi Commercial Bank was formed

in 1983 to take over the remaining branches of three foreign banks (United Bank

of Pakistan, Bank Melli Iran and Banque du Liban d’Outre Mer). This completed

the process of conversion of foreign bank branches into strong joint-venture banks

involving foreign and Saudi shareholders. In 1984 the Saudi Investment Bank was

given a full commercial license.And in 1988 a license was given to Al Rajhi Banking

and Investment Corporation to convert the Al Rajhi family’s money changing

business to a full-fledged commercial bank.With these developments,by 1990 the

Saudi banking system had 12 commercial banks, 9 with foreign shareholders.

Laying the foundation for a securities market. In 1982 SAMA introduced

Bankers Securities Deposit Accounts, a forerunner to the Treasury bills that

followed. Also in 1985 the government issued new rules through SAMA per-

mitting the creation of a stock market. A supervisory committee that included

senior officials from SAMA, the Ministry of Finance and the Ministry of

Commerce was established to develop rules and regulations and to establish

a surveillance system. The day-to-day operations of the share market and its

supervision were left to SAMA.


252

In 1988 the Saudi government introduced the Government Development

Bonds program to provide investment instruments to banks and other

investors in the country. SAMA issues government securities on behalf of the

Ministry of Finance. SAMA put in place an arrangement whereby banks could

repo up to 25 percent of their Saudi government bond holdings with SAMA.

This limit was subsequently increased to 75 percent.

Improving services through technology. In the early 1980s SAMA developed

a comprehensive strategic plan to modernize the banking system that included:

• Automated check clearing.

• Links to the SWIFT payment network.

• A national automated teller machine system.

• Debit, credit and charge cards.

• Point-of-sale terminals to link customers, traders and banks.

As a result of these arrangements, a stronger banking system emerged

despite the tumultuous economic conditions. The number of branches, 247 in

1980, reached 1,036 by end of 1990. Three new banks—Al Rajhi Banking and

Investment Corporation, Saudi Investment Bank and United Saudi Commer-

cial Bank—were added to the list. The number of employees also rose signifi-

cantly, from 11,000 in 1980 to about 25,000 in 1990. Today, Saudis represent

about 80 percent of all employees in the banking sector. And major Saudi banks

opened branches in Bahrain, Beirut, Turkey and the United Kingdom.

CHALLENGES OF THE 1990S—SYSTEMIC STABILIT Y

AND CONSOLIDATION

The Gulf crisis. By the beginning of the 1990s the Saudi banking system had

largely recovered from the difficulties of the mid-1980s. Banks had expanded

their branch network, introduced stronger management methods and new

technologies, raised new capital, improved their profitability and set aside

large provisions for doubtful accounts. They were healthy and profitable. But

with the invasion of Kuwait by Iraq in August 1990, the Saudi banking system

faced another challenge. Customer withdrawals that month were 11 percent

of total deposits, largely converted into foreign currency and transferred

abroad. But by September the pressure had eased. SAMA had ensured the

availability of foreign currency to meet customer demands by providing more

liquidity through repo arrangements and placing foreign currency deposits

with the banks. Banks also coped by liquidating their foreign assets. By end of

1990 the banking systemwide deposits had returned almost to their level at the

beginning of 1990, and the year-to-year decline was only 1.6 percent.

SAUDI ARABIA

253

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.

RECENT LEGISLATIVE CHANGES

In support of the government policy of further economic liberalization, the

pace of broadening and opening the financial sector has picked up signifi-

cantly. The Saudi government is bringing in a string of legislative and proce-

dural changes to permit rapid growth and innovation.

Foreign investment law. In April 2000 the government promulgated a

new Foreign Investment Act introducing major changes to the existing legal

and regulatory framework and ushering in a new era of foreign investment

in Saudi Arabia. The act had direct implications for the financial sector as it

further opened up the Saudi market to foreign investments, including 100

percent foreign-owned companies. It also created the Saudi Arabian General

Investment Authority (SAGIA) to issue licenses to companies for most


254

investment activities. The main objective of SAGIA is to oversee the invest-

ment affairs in the country, including foreign investments.

Since its creation, SAGIA has developed new laws and reforms to encour-

age investment. Hundreds of new investment projects have been approved

with billions of dollars new investment. In 2000 Saudi Arabia also introduced

changes to the tax system whereby the income tax to be paid by foreign com-

panies and investors in the highest tax bracket was reduced from 45 percent

to 30 percent. It was further reduced to 20 percent in January 2004. This has

very positive implications for existing and future foreign investors in the finan-

cial sector.

New capital market law. A Capital Market Law, promulgated in June

2003, establishes a new government regulatory body, the Securities Exchange

Commission, with authority to make and enforce rules and regulations. The

commission will be the primary regulatory body for capital market activi-

ties, with the responsibility to promote the development of an efficient,

vibrant, fair and transparent market. It will also be responsible for initiatives

to deepen and broaden the securities market. The provisions of the law are

consistent with standards published by the International Organization of

Securities Commissions (IOSCO), bringing Saudi Arabia’s securities laws

into the mainstream of modern securities regulatory practices embraced by

IOSCO members.

The law also envisages the creation of Saudi Arabian Securities Exchange,

a privately owned company governed by a board of directors that will include

members from the private and the public sectors. A self-regulatory organiza-

tion, the exchange will be the exclusive market for publicly traded securities.

It will have sole authority to settle and register transactions of securities.

New insurance law. More than 150 domestic and international companies

operate in various forms—joint-stock companies, branches, agencies, broker-

age houses. Many unlicensed companies and agents sell a range of insurance

and investment products, including automobile, life, health and education poli-

cies. These companies take billions of dollars in annual premiums and gener-

ally invest in foreign financial markets.

The new law, promulgated in 2003, provides for the Saudi Arabian Mone-

tary Agency to become the licensing and regulatory authority for insurance.

All market participants are to be licensed, and a regulatory infrastructure is

being developed to ensure a competitive and transparent market. SAMA has

already developed an organizational framework and an experienced supervi-

sory team to regulate this important sector.

SAUDI ARABIA

255

PROSPECTS FOR THE NEXT DECADE

Over the past half century the Saudi economy, like other oil economies, has

been buffeted by the turbulence of the oil market. But its financial system has

remained sound, stable and credible. No Saudi bank has ever failed. And bank-

ing problems were skillfully resolved by the authorities using various super-

visory tools and techniques.

Strong supervisory framework. SAMA has used its broad supervisory pow-

ers effectively to ensure that the Saudi banking system continues to enjoy a rep-

utation for soundness and stability in the international financial markets. It

has been an active player in the international banking supervisory world and

has benefited greatly from its participation in several international forums. It

also participates in several subcommittees of the Basel Committee on Banking

Supervision, particularly the Core Principles Liaison Group, which helped

develop the Basel Core Principle for Effective Banking Supervision. In addi-

tion, SAMA participates in various projects, studies, surveys and work con-

ducted by the International Monetary Fund and the World Bank and other

multilateral institutions in the areas related to financial sector supervision.

Enhanced corporate governance. SAMA has guidelines for members of the

board of directors of Saudi banks on their responsibilities. It also has guidance

and rules for internal controls, the internal audit function and the internal

audit committees. It required Saudi banks to appoint two external auditors

from the leading international audit firms. And it insisted that banks follow

both the Saudi Arabian and the international accounting standards to pre-

sent their financial statements. In recent years SAMA has required all Saudi

banks to implement IAS #39, a major step toward fair value accounting. SAMA

has also actively encouraged Saudi banks to participate in the annual Basel

Committee Survey of Transparency of International Banks. Currently Saudi

banks’ financial statements reflect the highest level of transparency among the

banks of the emerging market countries.

New technology. Looking ahead, the Saudi Financial and Banking System

is poised to take advantage of its large investments in new technologies. Most

important, there is still room for the full utilization of the capabilities of the

1997 Saudi Riyal Interbank Express, a real-time gross settlement electronic

fund transfer system. This system is the backbone of the Saudi payments infra-

structure with significant capacity to enhance all other payment and settle-

ment systems. It also provides capabilities for B2B and B2C business

applications. Another electronic share-trading and information system

(Tadawul) has recently been enhanced to provide settlement capability and to


256

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.

THE 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

SAUDI ARABIA

257

liberalization, its large investment in technology and its strong supervisory

infrastructure. Entering a new era that demands increased participation,

greater competition, enhanced transparency and strong supervision and cor-

porate governance, it is in a strong position to rise to these challenges and

meet the demands of the rapidly growing economy. The recent legislative and

regulatory changes augur well for a bright future.


258

UNITED KINGDOMThe 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

THE SITUATION IN THE UNITED KINGD OM BEFORE 1997The liberalization of the United Kingdom’s capital markets, which has been

extensive and long-running, included removing indirect controls on bank

lending and deregulating the securities market. Exchange controls were abol-

ished in 1979. The United Kingdom is now one of the most open and liberal-

ized capital markets in the world.

Before 1997 the financial sector was subject to a mix of self-regulation,

central bank supervision and government regulation.

From the early 1980s there was a shift away from self-regulation in the

banking and securities sectors toward statutory regulation. This arose because

the self-regulatory system was vulnerable to industry capture, to the detri-

ment of consumers. The large number of self-regulatory bodies also created

confusion for the industry and for consumers.

The Financial Services Act 1986 introduced some reforms while retain-

ing some of the benefits of self-regulation. The new arrangements drew some

criticism after a while for being bureaucratic and unwieldy, while still being

susceptible to industry capture and not protecting consumers enough.

The banking sector was supervised by the Bank of England, which ran a

two-tier system, exercising greater power over deposit-taking banks than over

259


260

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.

INSTITUTIONAL REFORMS SINCE 1997An important element in building sound institutions is to avoid conflicts of

interest. Where one aspect of policy has to be compromised to meet another,

credibility will be lost. Experience shows that it is better for monetary policy,

fiscal policy, debt management and financial regulation to have separately

identified objectives, with responsibility for achieving them clearly attribut-

able to one institution each.

In the United Kingdom the Bank of England has responsibility for oper-

ating monetary policy, the Financial Services Authority for financial services

regulation and the Debt Management Office has operational responsibility

for carrying out the government’s debt management policy. Giving institutions

a single objective can help them focus their efforts more directly and enhance

accountability.

Effective financial regulation should be combined with an effective finan-

cial stability framework to maintain market and consumer confidence, safe-

guard consumer welfare and maximize the potential benefits of liberalization

and globalization.

MONETARY AND FISCAL POLICY REFORM

A new macroeconomic policy framework was established in 1997 with the

aim of raising the sustainable rate of economic growth and achieving ris-

ing prosperity by creating economic and employment opportunities for all.

This is achieved through the independent operation of monetary policy

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.

REGULATORY 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.

261

The United Kingdom’s modelIn 1997 the government inherited a complex and fragmented regulatory struc-

ture.2 There were separate prudential regulators for banks, insurance compa-

nies and building societies.

The blurring of boundaries between different types of institutions and

financial products was pronounced, and the regulatory structure no longer fit

the financial sector well.

Structure of the Financial Services AuthorityThe United Kingdom’s new macroeconomic framework is based on a con-

strained discretion model. This recognizes that, in an open economy, rigid

rules do not produce reliable targets for achieving long-term stability. Instead,

the discretion necessary for effective economic policy—short-term flexibility

to meet credible long-term goals—is possible only within an institutional

framework commanding market credibility and public trust, in which the

government is constrained to deliver clearly defined long-term policy objec-

tives, maximum openness and transparency. This approach enhances the effec-

tiveness of policy.

The key principles for a framework of credible constrained discretion are:

• Clear and sound long-term policy objectives.

• Pre-commitment through institutional arrangements and proce-

dural rules.

• Maximum openness and transparency and clear accountability.

This model was applied in monetary policy by giving operational inde-

pendence to the Bank of England in 1997. There is a clear division of respon-

sibilities between the government and the central bank. The elected

government sets the wider economic strategy and, within that, the objectives

for monetary policy and the inflation target. Monthly decisions to meet that

target are passed over to the central bank. This removes tactical decisions on

interest rates from the political process. The government and the Bank of

England are constrained by pre-committing to the long-term stability of the

target, but the Bank of England is granted discretion to respond flexibly to

changing economic conditions.

In financial services regulation this model was applied to the formation

of the Financial Services Authority (FSA). The Government, through the

finance ministry (the Treasury), retains responsibility for the overall institu-

tional structure of financial services regulation and sets the FSA’s long-term

policy objectives. The FSA has operational responsibility for delivering these


262

objectives and is accountable for doing so in a framework that maximizes

transparency.

Four key principles defined the shape of the new regulatory regime for

financial services in the United Kingdom:

• A single organization should be responsible for financial services

regulation.

• A single statute should set out the framework under which the regu-

lator operates.

• The regulator should be operationally independent from the monetary

authority and the government but still accountable to the government.

• A tripartite arrangement for addressing financial stability issues

should be established setting out the respective responsibilities of the

regulator (FSA), the central bank (Bank of England) and the finance

ministry (Treasury).

Financial Services and Markets Act 2000The FSA acquired its responsibilities in two stages. First, the Bank of England

Act 1998 transferred responsibility for the supervision of banks and money-

market institutions from the Bank of England to the FSA. The second stage

involved the creation of a new statutory regime under which the FSA

operated—the Financial Services and Markets Act 2000—which came into

force on 1 December 2001. The act reoriented the United Kingdom’s approach

to regulation through its statutory objectives and principles of good regulation.

Four statutory objectives define the role and functions of the FSA. In

essence, these are maintaining market confidence, promoting public aware-

ness, protecting consumers and reducing financial crime.

In pursuing these objectives the Financial Services and Markets Act

requires the FSA to follow seven principles of good regulation. The first three

cover the efficient and economic use of regulatory resources, good corporate

governance and proportionate regulatory costs imposed on bodies. Four

other principles give prominence to competitiveness, reflecting the concern

that regulation should not unnecessarily obstruct or distort competition and

innovation.

Before the Financial Services and Markets Act the desired outcomes of

financial sector regulation were not transparently defined. In creating a set of

statutory objectives the act established a foundation on which the organiza-

tional structure of the FSA could be built and against which regulatory per-

formance could be judged.

UNITED KINGDOM

263

The FSA is a private company discharging a public function and has

regulatory powers conferred on it by statute. The FSA does not rely on cen-

tral government funding, but it does have the power to levy fees on all the

firms it regulates to cover the costs of its functions as defined by the act.

The Financial Services and Markets Act did not widen the scope of the

FSA in any significant way beyond those activities and products already reg-

ulated. Responsibility for regulating the listing of shares was transferred from

the London Stock Exchange to the FSA in May 2000. The FSA’s remit was

extended to the regulation of mortgages and long-term care insurance in

October 2004 and to the regulation of general insurance in January 2005.

The Financial Services and Markets Act confers wide powers on the FSA

to create and enforce rules. The FSA can create detailed rules without con-

sulting parliament, and these rules have the force of law.

The act has several mechanisms to hold the FSA accountable. These are

designed to make the FSA transparent and proportionate in its actions and can

be broken down into three groups:

• Accountability of the FSA as an organization.

• Accountability of FSA rulemaking.

• Accountability of FSA decisions.

Accountability of the FSA as an organization. The FSA must explain what

progress it has made against its statutory objectives and principles of good reg-

ulation in an annual report to the Treasury. This is also presented to parlia-

ment and published.

Under the terms of the Financial Services and Markets Act, the Treasury

is able to initiate independent performance reviews of the FSA.

The board of the FSA must include a majority of nonexecutive directors

who are required to report on the efficiency of the use of FSA resources. The

board is appointed, and may be dismissed, by the Treasury.

Two statutory panels are established under the act—the Financial Services

Practitioner Panel and the Financial Services Consumer Panel. Both bodies are

independent of the FSA and may make direct representations to the FSA board.

The FSA is obliged by the act to have regard to the recommendations of the

panels. Where the FSA disagrees it must provide reasons. The Financial Services

and Markets Act also establishes an independent Complaints Commissioner

who investigates complaints made about the FSA’s exercise of its functions.

Accountability of FSA rulemaking. Accountability in setting FSA legislation

(rules, codes, general guidance and general policies) is delivered through

requirements for consultation. Consultation must be accompanied by, among


264

other things, a cost-benefit analysis and an explanation of the FSA’s reasons

why it believes that proposed rules are compatible with the FSA’s statutory

objectives and principles of good regulation.

Accountability of FSA decisions. FSA-authorized persons may appeal FSA

enforcement decisions through the Financial Services and Markets Tribunal, an

independent, statutory body that rehears the case in question.

Risk-based supervisionA 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.

Independence from the monetary authorityAn important characteristic of the United Kingdom’s financial sector regula-

tory regime is that it remains independent of the monetary authority (the

Bank of England).

Supervision of the banking sector by the central bank carries the risk that

problems with banking supervision can impair the central bank’s reputation.

This may harm the credibility of monetary policy if it is a central bank respon-

sibility. Conversely, monetary policy may be used to mask the effects of weak

banking regulation. This can also damage the credibility of monetary policy,

unless responsibility for monetary policy and responsibility for banking super-

vision are separated.

Tripartite financial stability frameworkThe United Kingdom established a framework for cooperation between the

Treasury, the Bank of England and the FSA in the field of financial stability.

Details of this framework are set out in a Memorandum of Understanding

signed by the three institutions in 1997. It clearly sets out the role of each

institution and how they work together to deliver the key objective of finan-

cial stability. The division of responsibilities is based on four principles: the

clear accountability of each institution, transparency to parliament, the mar-

kets and the public, no duplication of effort and regular information

exchange.

UNITED KINGDOM

265

Under the terms of the Memorandum of Understanding the Bank of

England is responsible for the overall stability of the financial system, which

involves monitoring the stability of the monetary system, developing and

strengthening financial system infrastructure to help reduce systemic risk and

taking a broad overview of the system as a whole. Responsibility for day-to-

day supervision of the financial sector and for the conduct of regulatory pol-

icy rests with the FSA. The Treasury is responsible for the overall institutional

structure of financial services regulation and for the legislation governing it.

The Treasury has no operational responsibility for the activities of the Bank

of England or the FSA.

The Memorandum of Understanding also established a tripartite stand-

ing committee to ensure effective exchange of information between repre-

sentatives of the Bank of England, FSA and Treasury. A monthly forum for

proactive discussion, the standing committee has strengthened the ability of

the United Kingdom’s institutions to monitor and maintain financial stabil-

ity. In the period since 11 September 2001 it has also proved effective in coor-

dinating the work of the three institutions in promoting the resilience of the

United Kingdom’s financial system to the increased threat of major opera-

tional disruption.

The tripartite financial stability framework also provides the basis for the

institutions’ contingency planning for managing a crisis affecting the financial

sector should it occur, whether it is of a financial nature or operational nature.

An essential part of the success of this framework has been the existence

of a single unified body in the shape of the FSA. Before this was established,

it would have been a major challenge to get the nine separate financial regu-

lators to work closely together in this way.

COMPLEMENTARY SECOND-LEVEL INSTITUTIONAL REFORMS

These major institutional reforms to financial services regulation and finan-

cial stability affected complementary institutional frameworks, particularly

those relating to the management of United Kingdom’s government debt and

payment and settlement systems.

Debt Management OfficeAs part of the reforms to the macroeconomic framework announced by the

Chancellor of the Exchequer in 1997, the government transferred responsi-

bility for debt and cash management from the Bank of England to the

Treasury. In April 1998 the United Kingdom’s Debt Management Office


266

(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).

Payment and settlement systemsThe payment systems infrastructure underpins the overall financial system.

Its oversight is a key element of the Bank of England’s responsibility for the

stability of the financial system as a whole (Bank of England 2000). Payment

system oversight is based on the 10 Core Principles developed by the

Committee on Payment and Settlement Systems (Bank for International

Settlements 2001). These principles cover legal soundness, financial and set-

tlement risk, security and operational reliability, efficiency, access rules and

governance.

The United Kingdom’s main high-value payment system is the Clearing

House Automated Payment System. Although it fully complies with the 10

core principles, there have been moves to improve the system’s governance

and risk management framework. Retail payment services are provided by the

Bankers’ Automated Clearing System and other mechanisms.

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267

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.

IMPACT OF FINANCIAL SECTOR INSTITUTION BUILDING

The purpose of developing new institutional frameworks for regulating the

financial services sector and for monetary and fiscal policy was in part to sup-

port ongoing financial stability—a prerequisite for sustained economic growth

and increased employment.

The changes to the United Kingdom’s monetary and fiscal policy frame-

works have had a positive impact on macroeconomic stability. Inflation,

markedly more stable since 1997, has remained much closer to expectations

than had previously been the case. Despite a period of global uncertainty, the

United Kingdom’s economy has continued to grow and it is experiencing the

longest unbroken economic expansion on record.3

The IMF’s financial stability indicators show that banks in the United

Kingdom remain well capitalized and profitable despite recent falls in equity

markets—and that they have relatively low rates of nonperforming loans

(Bank of England 2003). Results of stress tests developed by the IMF and

authorities in the United Kingdom indicate that these banks should remain

profitable in the face of relatively large shocks.

While the robustness of the financial sector reflects in part a sound and

credible monetary policy regime, financial stability remains a crucial factor in

sustaining macroeconomic stability and thus the conduct of that monetary

policy.

The robustness of the United Kingdom’s financial sector cannot be

explained by the presence of macroeconomic policy frameworks alone. It owes


268

much to the structure and nature of financial services regulation—

proportionate, objectives-driven and risk-focused.

IMF AND WORLD BANK FINANCIAL STABILITY ASSESSMENT PROGRAM

The reports published under the Financial Stability Assessment Program

(FSAP), a joint IMF and World Bank program, provide a rigorous and objec-

tive view of the United Kingdom’s regulatory framework. They seek to iden-

tify the strengths and vulnerabilities of a country’s financial system, determine

how key sources of risk are being managed, ascertain the sector’s develop-

mental and technical assistance needs, and help set priorities for policy

responses.

As part of the FSAP, the United Kingdom received a Financial System

Stability Assessment (FSSA). This provided an analysis of the strengths and

areas for development of the United Kingdom’s reformed system.

The FSSA highlighted the importance of coordination between the key

players (Bank of England, the FSA and the Treasury) in the tripartite finan-

cial stability framework. It noted the overall coherence of the United

Kingdom’s regulatory structure and its adherence to principles of clarity and

accountability. Monitoring work by the Bank of England and the FSA was

acknowledged to be of a high quality, and the United Kingdom’s payment and

settlement systems were seen to have made good progress over the years.

An important element of the FSSA is the completion of Reports on the

Observance of Standards and Codes, which monitor the extent to which coun-

tries observe international standards and codes. These standards and codes are

an important component of financial stability in an increasingly globalized

world and are relevant for all countries. The United Kingdom was assessed

against a range of codes and standards modules and is ready to be assessed

against several newer modules.

The United Kingdom’s experience of the FSAP was very positive. The United

Kingdom would encourage other countries to engage in this process, not only

because of the benefits that accrue to each individually, but also because of the

positive effects for global financial stability through the sharing of best practice.

PERFORMANCE OF THE FSAIn assessing the effectiveness of institutional reform, the performance of the

FSA against its statutory objectives should also be considered.

• Maintenance of market confidence. Reports from the Financial Services

Practitioner Panel indicate that market confidence has remained high,

UNITED KINGDOM

269

that the presence of a strong regulator with cross-sectoral reach has

been welcomed by the vast majority of practitioners in the United

Kingdom and that regulation is seen to be proportionate.

• Promoting public awareness. Education of consumers is an important

prerequisite for allowing the regulator to strike the correct balance

between consumers and providers. To date, the FSA’s education ini-

tiative has worked well, and the FSA plans to build on this in the

future.

• Protecting consumers. The regulatory regime does not aim to protect

consumers from all risks to their investments. One of the key chal-

lenges for the FSA has been to explain the limitations of the con-

sumer protection regime. Progress by the FSA toward this objective

has largely been through the successful implementation of the

broader regulatory framework.

• Reducing financial crime. The FSA has worked alongside the Treasury

and the United Kingdom’s law enforcement authorities to push for-

ward the implementation of the Financial Action Task Force’s 40

recommendations for anti–money laundering and its 8 special rec-

ommendations for combating the financing of terrorism.

FUTURE 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 supervisionFollowing 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.


270

European Union and global developmentsThe nature of global markets means that financial regulators need to work across

borders. Many of the reforms that should be implemented in the United

Kingdom in the near future relate to developments at the European and inter-

national levels. The ability of the United Kingdom to react in a coordinated man-

ner to proposals for improved standards arising from international requirements

has been enhanced through the tripartite financial stability framework.

Since 1998 the Bank of England and the FSA have been working with

other authorities responsible for banking supervision on the revision and

implementation of the Basel Capital Accord. The Bank of England and the FSA

also participate in the range of international standards-setting bodies work-

ing to strengthen the global financial architecture, such as the International

Organization of Securities Commissions, the International Association of

Insurance Supervisors and the Financial Stability Forum.

The United Kingdom’s relationships with other EU states is of great

importance in shaping further reform. The United Kingdom has been at the

forefront in encouraging improved cooperation and coordination among EU

supervisors, including through the establishment and extension of the

Lamfalussy arrangements designed to make the EU regulatory process more

efficient and transparent.

The United Kingdom also recognizes the importance of diversity in

national regulatory regimes. A successful institutional model in one country

may not be suitable for another. The regime in the United Kingdom is founded

on broad principles of good regulation, implemented through an institutional

structure tailored to fit the nature of the United Kingdom’s financial sector. It

is these principles that the United Kingdom hopes to build on with its EU and

international partners.

CONCLUSIONS

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:

UNITED KINGDOM

271

• Ever-more globalized financial markets may pose threats to financial

stability. A comprehensive and effective financial stability framework

therefore becomes more important, and the institutional structure

chosen to implement that framework can have a crucial impact on its

efficiency.

• Reforms should be introduced as part of a broader strategy, not as a

piecemeal response to crises.

• The constrained discretion model has a number of fruitful applica-

tions (financial regulation, fiscal policy, debt management) beyond

the more familiar field of monetary policy.

• Key principles in applying the constrained discretion framework are

clarity, transparency and accountability. Combined, these deliver the

credibility that underpins stability.

• Reform is not a one-off event. It is an ongoing process to continually

develop and improve the institutional structures supporting financial

stability.

• The use of an objective assessment tool, such as the IMF and World

Bank Financial Stability Assessment Program, is very helpful in

identifying strengths and areas for development. It is an important

way of setting benchmarks for measuring future performance—

and of sharing best practice. Wider engagement in the FSAP and

corollary Reports on the Observance of Standards and Codes pro-

gram by all countries is something the United Kingdom would

recommend.

NOTES

1. For more information on the mechanics of liberalization and market devel-opment in the United Kingdom, please see Her Majesty’s Treasury (2003), whichdeals in more depth with the United Kingdom’s complementary institutionalreforms to monetary and fiscal policy.

2. There were nine separate predecessor agencies regulating the same areathat the Financial Services Authority now regulates. They were the InvestmentManagement Regulatory Organization, the Personal Investment Authority, theSecurities and Futures Authority, the Insurance Directorate of the Department ofTrade and Industry, the Bank of England, the Securities and Investments Board,the Building Societies Commission, the Registry of Friendly Societies and theFriendly Societies Commission.

3. The United Kingdom has now experienced 49 consecutive quarters of pos-itive GDP growth.


272

REFERENCES

Bank for International Settlements. 2001. “Core Principles for SystematicallyImportant 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 WhereNow? London and New York: Routledge.

Her Majesty’s Treasury. 2003. “Macroeconomic Frameworks in the New GlobalEconomy.” London. [www.hm-treasury.gov.uk/media/B6356/admacro02-249kb.pdf].

United Kingdom. 2003. “Financial System Stability Assessment Including Reportson the Observance of Standards and Codes.” London. [www.imf.org/external/np/fsap].

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UNITED STATESThe 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

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275

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.

INSTITUTIONALIZING TREASURY NOTE AND B OND AUCTIONS

Substituting a market-driven auction for fixed-price offerings between 1970

and 1975 increased the efficiency and liquidity of the U.S. Treasury securities

$ billions

Figure 1. Holdings of U.S. Treasury securities, 1980–2003

0

1,000

2,000

3,000

4,000

200320001998199619941992199019881986198419821980

Total held by public

Total foreign (official and private)

Private foreign

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.

Fixed price offerings before 1970Before 1970 the U.S. Treasury did not auction many notes or bonds, but it did

auction bills more or less as it does today. It raised new cash from fixed-price

subscription offerings, and it refinanced maturing debt with subscription

offerings and fixed-price exchange offerings. In a subscription offering the

Treasury set the maturity date, coupon rate and offering price of a new issue;

announced how much it wanted to sell; and invited public subscriptions at the

specified price. It typically accepted all subscriptions for amounts below some

stated threshold and allocated the remaining notes or bonds to larger sub-

scribers in proportion to the amounts sought. Before setting the terms of an

offering, officials consulted with a variety of market participants to assess

demand and to identify the yield needed to meet its objectives.

By setting terms this way, the Treasury bore the risk of misjudging mar-

ket demand. If it set the yield too low, the issue would be undersubscribed, and

the offering would fail. The risk of a failed offering was compounded by the

possibility that unforeseen events or new information on the economy might

raise market yields between the time a new issue was announced and the time

the subscription books were opened (usually an interval of several days to a

week).4 To limit the likelihood of an undersubscribed offering, the Treasury

typically added a premium to contemporaneous market yields when setting

the terms. This sometimes led to substantial oversubscriptions and low allot-

ment ratios—signs that the Treasury was giving away yield at taxpayer expense.

Subscriptions were further inflated by the rational response of investors to

the prospect of receiving fewer notes or bonds than desired.5

In an exchange offering the Treasury set the maturity dates and coupon

rates on new notes or bonds and invited the public to exchange one or more

designated maturing issues for the same principal amount. (An offer might

also provide for a small cash payment for accrued interest or because of an off-

market coupon.) The Treasury typically announced that it would accept all

tenders. To finance cash redemption of unexchanged securities, or “attrition”,

the Treasury sometimes announced a concurrent cash subscription. Other

times the Treasury’s cash balances were large enough to fund the redemption

of any unexchanged securities. By the late 1950s a large share of U.S. Treasury


276

notes and bonds matured regularly in mid-February, mid-May, mid-August

and mid-November, and exchange offerings to refinance these issues came to

be called “mid-quarter refundings”.

As with subscription offerings, a drawback to exchange offerings was that,

in setting the terms, the U.S. Treasury bore the risk of setting the yields on new

issues too low, causing unexpectedly high attrition and exposing the Treasury

to a cash flow crisis. To limit this risk, a premium was usually added to con-

temporaneous market yields when setting the terms of an offering.6 Because

exchange offerings gave investors a choice of several different securities, the

Treasury lost direct quantitative control of the maturity structure of its debt.

It could try to alter investor demand by adjusting the offer terms across the

term structure, but the precision of indirect control was limited.

The debate over auctionsThroughout the 1950s and 1960s the U.S. Treasury was auctioning bills much

as it does today. In bill auctions, an investor could submit one or more com-

petitive tenders or a single noncompetitive tender. A competitive tender

specified a bid price and the quantity of bills desired at that price. A non-

competitive tender specified only a quantity (limited to a specified maxi-

mum) with an agreement to pay the average accepted competitive bid. The

Treasury accepted all noncompetitive tenders for the full amount sought.

Competitive tenders were accepted in order of declining bid price until the

balance of the offering was accounted for. Tenders specifying prices in excess

of the stop-out, or minimum accepted price, received the full amount sought

and were invoiced at their bid price. The remaining bills were distributed in

proportion to the quantities sought among those who bid at the stop-out

price.

The Treasury’s reservations about using auction offerings for its notes

and bonds rested mainly on the premise that many small banks, corporations

and individuals that subscribed to fixed-price offerings did not have the “pro-

fessional capacity” to bid in an auction. They would be relegated to the sec-

ondary market, and the Treasury would not distribute its debt as widely as

possible. With relatively few expert market participants, it was feared also that

auctions would not always be competitive and that they would fail from time

to time. The Treasury worried as well that sophisticated buyers would venture

low bids on the chance that they would be accepted, increasing financing costs.

As proof, critics pointed to the previous unsuccessful experiences with auc-

tions of long-term bonds in 1935 and in 1963.

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The renewed effort to auction coupon-bearing securitiesBy the middle of 1970 the cost of issuing fixed-price offerings was rising due

to high and volatile interest rates. Criticism that subscription and exchange

offerings were inefficient intensified, and support grew for auctions, especially

single-price auctions.7 The idea was that unsophisticated bidders might be

less deterred by single-price auctions and that they might yield more revenue

than multiple-price bidding. In November 1970 the U.S. Treasury decided to

try again to auction coupon-bearing debt on a regular basis. Having learned

from its experience with introducing bill auctions, it first auctioned short-

term notes, then notes of progressively longer terms. It auctioned long-term

bonds only after several years of successful auctions of shorter-term debt. As

it turned out, this sequential approach allowed dealers to develop the risk

management and sales programs needed to support auction bidding.

The initial auction for a small amount of 18-month notes at the Novem-

ber 1970 refunding closely followed the multiple-price bill auction format

familiar to market participants. After its success, the U.S. Treasury followed up

with several additional auction offerings over the next 10 months, but the

auction method was used sparingly and only for short-term notes. After the

August 1971 refunding the Treasury increased the frequency and maturities

of its auction offerings, and in December 1972 it announced the auction of

long-term bonds in a new single-price format. By mid-1973, auction sales of

notes and bonds had effectively replaced subscription and exchange offerings.

The August 1973 refunding produced a setback when fixed-income secu-

rities prices declined sharply between the announcement of the auction and

the date for receipt of tenders. That auction’s failure led to important changes

in Treasury auction procedures. First, the Treasury began to delay announce-

ment of the coupon rate until closer to the auction. In September 1974, aim-

ing to further reduce the risk of an off-market coupon, the Treasury replaced

competitive bidding in terms of price with bidding in terms of yield (on a

security with no specified coupon). In this new procedure, tenders were

accepted in order of increasing yield until all the securities left by non-

competitive bidders were accounted for. After the auction, the Treasury set

the coupon rate at the highest level that gave an average price on the accepted

competitive tenders not in excess of par. Each accepted tender was invoiced at

its own bid yield, and noncompetitive tenders were invoiced at the average

accepted competitive price.

Another important step in early 1975 was the removal of restrictions on

trading a security before issuance—so-called when-issued trading. In contrast


278

to secondary market transactions in outstanding Treasury securities, which

typically settle on the business day after the trade, when-issued transactions set-

tle on the issue date of the security, which may be several days or even weeks

after a when-issued trade is negotiated. By providing information about mar-

ket participants’ appraisal of a prospective issue, the when-issued market greatly

increased bidding efficiency and facilitated distribution.8

THE FEDERAL RESERVE’S B O OK-ENTRY SYSTEM

Until 1966 U.S. Treasury securities were issued in the form of “definitive”

bonds: engraved certificates setting forth the government’s promise to pay.

Starting in 1966 Treasury securities began to dematerialize into “book-entry”

instruments in computer memories and data storage devices. The result of

this process two decades later was a much more efficient Treasury market with

much lower operating costs. Except for residual amounts of a handful of issues

due to mature by the end of the decade, definitive bonds no longer exist.

Ownership and transfer of definitive Treasury securitiesDefinitive bonds came in two forms: bearer and registered. (Definitive bills

were issued only in bearer form.) A bearer bond comprised a “corpus”, or main

body, with the government’s promise to pay principal and interest, and a series

of detachable coupons, each of which was a claim to an interest payment on

a specific date. The government’s promises ran to the bearer of the bond. Since

the U.S. Treasury could not identify bearers, it could not disburse payment on

its own initiative. Thus, to claim an interest payment (or principal at matu-

rity), a holder had to detach the appropriate coupon and send it (or the cor-

pus) through the banking system to a Federal Reserve bank for collection.9 The

bondholder also could transfer ownership of the claims by physically deliver-

ing the engraved certificate.

A bond was said to be registered if the government’s promise to pay prin-

cipal and interest ran to a person whose identity was recorded with the Treasury.

An engraved certificate was associated with each registered bond, and on its face

was the name of the registered owner. To transfer a registered bond to a new

owner, an investor had to inform the Treasury by following the re-registration

instructions on the back of the bond. Upon receipt, the Treasury would change

its records and issue a new certificate to the new owner. Knowing the name and

address of any bond’s owner, the Treasury could send checks for periodic inter-

est payments without requiring tender of coupons. For the payment of prin-

cipal, however, the Treasury required tender of the certificate to recover

UNITED STATES

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matured certificates. Bondholders could have bearer or registered bonds, and

they could change from one form to the other with no direct cost.

Advantages and disadvantages of bearer and registered bondsBonds were easily transferred from one owner to another, but because posses-

sion was tantamount to ownership, they had to be kept safe from loss, destruc-

tion and theft.10 Institutional owners either maintained their own security vaults

or contracted with commercial banks for custodial services. Conveying a bearer

bond to a new owner, whether across the street or across the country, required

secure transportation. Holders of bearer bonds, or their custodial agents, also

had to clip bond coupons and submit them for collection. For banks provid-

ing custodial services for many thousands of bonds this was a substantial and

costly effort. For registered bonds, safekeeping transport and payment were

simpler, largely because they could be replaced more readily. But changing the

record of ownership of a registered bond was time-consuming, and the Treasury

did not allow transfers during the 30 days before an interest payment.

Settling purchases and sales of definitive Treasury securitiesBefore 1966 investors valued U.S. Treasury securities for their liquidity and

creditworthiness. Most institutional investors kept their Treasury bonds, par-

ticularly short- and intermediate-term bonds, in bearer form so they could be

delivered quickly for sale. Large commercial banks maintained secure vaults

where they kept their own bills and bonds with the securities of their cus-

tomers, including customers who dealt in Treasury securities. Secondary mar-

ket transactions in bills, as well as a large share of bond transactions, were

settled by physical transfer of bearer securities from one bank to another—

mostly within New York City, but also between geographically remote banks.

Secondary market trading of registered bonds was much less common because

re-registration was so time-consuming and inconvenient.11

Moving bearer securities from one New York City bank to another to set-

tle a sale was neither cheap nor quick. The process typically took at least two

hours to complete. Transferring bearer securities between cities was even

slower and more expensive because of the time and cost of shipping—usually

by registered mail or armored carrier. An exception was when the transactors

were located in cities with Federal Reserve banks or branches. The transaction

could use a Commissioner of Public Debt (CPD) transfer, in which Federal

Reserve banks, on wired instructions, could use their inventories of Treasury

securities to credit (or debit) the accounts of local banks for the beneficial


280

ownership of their customers.12 Although CPD transfers greatly reduced long-

distance transportation costs, they did not affect the cost of intracity transfer

of securities between banks and customers or the cost of safekeeping.

Costs of safekeeping and transferring bearer securitiesBy the mid-1960s the costs of safekeeping and transferring bearer Treasury

securities were becoming increasingly burdensome for two reasons: rapid

growth of marketable outstanding Treasury debt caused more securities to fill

the increasingly limited space in bank vaults and concentration of that increase

at more frequently traded short and intermediate maturities meant more

transfers were required. Expanded trading of Treasury securities also began to

generate more settlement fails. The time required for an intracity delivery

(longer for an intercity delivery) limited custodial banks’ ability to redeliver

definitive securities more than once or twice a day. Since every transaction

had to be settled individually (because no netting schemes were in place),

market participants sometimes found themselves saddled with delivery oblig-

ations that they could not fulfill. These settlement fails were expensive for sell-

ers because they were not paid until delivery, and they exposed both buyers

and sellers to the risk of losses from counterparty failure.

The government securities clearing arrangementIn the winter of 1964–65, the Federal Reserve Bank of New York (FRBNY) offered

a novel netting arrangement for CPD transfers.13 Under the new Government

Securities Clearing Arrangement, during a business day FRBNY would allow a

bank to request by teletype a CPD transfer without simultaneously requiring

actual receipt of the securities involved. The FRBNY would maintain a record of

the bank’s requests, as well as of messages received from other Federal Reserve

banks requesting CPD deliveries to the same bank.At about 3 p.m. FRBNY would

compute the net transfers in each outstanding Treasury issue and request that the

bank settle up by delivering or receiving bearer securities.14 For all practical pur-

poses, this was an intraday book-entry system—a major departure from the

time-honored principle that transfers of government securities required physi-

cal delivery. In August 1966 FRBNY extended this arrangement to allow banks

to “redirect” incoming securities to other participating banks, a crucial step

because it allowed a bank to use book-entry credits to settle a delivery obligation

to another bank. Although the new arrangement reduced some costs for trans-

ferring ownership of Treasury securities, it still was not a full-fledged book-entry

system because accumulated credits and debits typically had to be extinguished

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by daily physical delivery.15 As a result, the arrangement did little to reduce the

need for vault space or coupon clipping.

Federal Reserve banks’ safekeeping of securitiesJust as the CPD transfer facility gave Federal Reserve banks experience receiv-

ing and delivering Treasury securities, Federal Reserve safekeeping operations

gave the Reserve banks important experience with custodial services. Reserve

bank operations in this area were based primarily on holding securities pledged

by member banks as collateral on discount window loans and against deposits

of public monies, such as Treasury Tax and Loan balances. Additionally, the

Reserve banks kept unpledged securities owned by geographically remote

member banks, so that securities would be readily accessible if a bank needed

to pledge them as collateral. FRBNY had particularly extensive experience in

this area because it safekept securities owned by the System Open Market

Account and by foreign central banks, as well as securities in federal govern-

ment accounts administered by the secretary of the Treasury.

Origins of the book-entry systemIn mid-1963, following an embarrassing loss of bearer Treasury securities at

the Federal Reserve Bank of San Francisco, the Federal Reserve Board exam-

ined whether Treasury securities owned by member banks and kept at Federal

Reserve banks could be converted to a book-entry form. Although the origi-

nal inquiry was limited to Treasury securities owned by member banks, offi-

cials recognized that Federal Reserve banks held securities for many other

parties and that the economic benefits of a book-entry system would be greater

with more securities. There were also substantial potential benefits to extend-

ing the system to securities owned by customers of member banks, especially

securities owned by nonbank dealers in Treasury securities.

The initial implementation of a book-entry system occurred in January

1968. Treasury and Federal Reserve officials decided to limit the first stage for

simplicity. The new system provided three categories of book-entry Treasury

securities: member banks’ securities held for investment (rather than for trad-

ing) and deposited with a Federal Reserve bank for safekeeping, member

banks’ securities pledged as collateral for a loan from a Federal Reserve bank

and securities pledged by a bank as collateral against Treasury Tax and Loan

balances and other federal government deposits. A member bank could

deposit Treasury securities (in bearer or registered form) to its book-entry

accounts, withdraw securities (in bearer or registered form) from its accounts,


282

order a transfer of book-entry securities to a book-entry account of another

member bank at the same Federal Reserve bank or order a CPD transfer of

securities held in book-entry form. Only two types of pledgees were allowed:

a Federal Reserve bank pursuant to a discount window loan and the U.S. gov-

ernment pursuant to a deposit of public monies.

Eighteen months after the initial implementation the Treasury and the

Federal Reserve banks made two important changes. First, they allowed any

Treasury securities to be deposited into an account maintained by a Federal

Reserve bank in its individual capacity for any purpose. The Reserve bank

would continue to act in its individual capacity with respect to the book-entry

securities in that account, clarifying the ability of the Reserve banks to act in

their individual capacities and as agents of the U.S. Treasury. This also enabled

the Reserve banks to make the book-entry system available to state and local

governments, to foreign central banks and for securities deposited for per-

formance of legal obligations (such as to secure deposits of trust funds). The

second major change was to extend the scope of the Treasury’s pre-emption

of state law on security interests to include all pledgees of book-entry Treasury

securities. This enabled the FRBNY to include in the book-entry system the

substantial volume of securities held for the System Open Market Account.

By the end of 1970 virtually all securities formerly held in Reserve banks

had been converted, and the Federal Reserve book-entry system accounted for

almost half the marketable outstanding Treasury debt. But three important

categories of Treasury securities remained entirely outside the book-entry sys-

tem: securities owned by member banks for trading (rather than investment),

securities owned by other customers of member banks and kept in member

bank vaults and securities held at member clearing banks for the account of

nonbank dealers (who accounted for a large share of all transfers). Purchases

and sales of securities in all these categories were still settled with costly deliv-

eries of bearer bonds. In addition, banks in New York City and other financial

centers had generally declined to deposit in book-entry accounts Treasury secu-

rities owned for investment purposes because of the excessive cost of comply-

ing with Internal Revenue Service identification regulations.

The insurance crisis and the accelerated expansion of the systemIn late 1970 after a series of large losses of bearer U.S. Treasury securities the

primary insurance writer for Treasury securities announced that it would

severely restrict or terminate coverage for banks. This threat to the liquidity

of the Treasury market forced authorities to expand the Federal Reserve’s

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283

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.

THE FEDERAL RESERVE’S SECURITIES LENDING PRO GRAM

A settlement fail occurs when a seller does not deliver securities to a buyer on

the originally scheduled date. Some fails are attributable to miscommunica-

tion or operational problems, but most fails occur because a dealer did not

receive the same securities in settlement of an unrelated purchase. Such “daisy

chain” fails can sometimes cascade, impairing market liquidity and distorting

securities prices. Concern over a rising tide of settlement fails in 1969 led the

Federal Reserve to initiate a program to lend Treasury securities from its

System Open Market Account portfolio. A 1999 revision introduced daily auc-

tions to make loan pricing more competitive. Today the program is an essen-

tial component of the Treasury securities market, as indicated by the more

than $1.5 billion in Federal Reserve securities lending averaged each day.

Borrowing and lending Treasury securitiesDealers and others borrow Treasury securities primarily to deliver against

short sales—that is, sales of securities that the seller does not own. A short sale


284

may be executed in a variety of circumstances: for example, under the belief

that the security’s price will be lower in the future, as part of a “spread” trade

(where one security is purchased and another sold short in anticipation of a

change in their relative prices), as a hedge against another position or to

accommodate the purchase interests of a customer. Normally, the short seller

returns the borrowed security when it closes out its short position with an off-

setting purchase. Treasury dealers commonly obtain Treasury securities using

reverse repurchase agreements, typically for same-day settlement—in effect,

borrowing securities and lending money.17

An important aspect of the market for borrowed securities is the distinc-

tion between a general collateral repo and a special collateral repo. A general col-

lateral repo is a repurchase agreement in which the lender is willing to accept

any of a variety of securities as collateral. The lender is concerned primarily with

earning interest and having securities that can be sold quickly at reasonably pre-

dictable prices if the borrower defaults. Interest rates on overnight general col-

lateral repos are usually close to the rates on overnight loans in the federal

funds market. A special collateral repo is a repurchase agreement in which the

lender seeks to borrow a particular security. The rate on a special collateral

repo is commonly called a “specials”rate, and each Treasury security has its own

rate. The difference between the general collateral repurchase agreement rate

and the specials rate for a security is a measure of its “specialness”.

If the demand to borrow a security is low relative to available supply, a

borrower will usually be able to lend at a rate no lower than 15–25 basis points

below the general collateral rate. If the demand to borrow a security is high

or if the available supply is limited, the specials rate for the security may be

materially below the general collateral rate and the specialness spread corre-

spondingly large. A dealer borrowing the security would then have to sacri-

fice a significant portion of the interest that could have been earned from

lending in the general collateral market. Exceptionally strong demand or lim-

ited supply can drive the specials rate for a security close to zero.18

Settlement failsAlthough 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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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

The Federal Reserve’s securities lending programThe idea of a Federal Reserve securities lending program can be traced to the

1950s, when ownership of medium- and long-term Treasury notes and bonds

was migrating from banks to pension funds and other institutional investors.

Some of the new money managers were slow to obtain authorization to lend

the investments that they managed, and the shrinking stock of loanable secu-

rities increased the incidence of settlement fails. The fails problem reduced

market liquidity because dealers were reluctant to accommodate customer

purchase interests without having the desired securities. Some market partic-

ipants advanced proposals to allow dealers to borrow securities from the sin-

gle largest owner of Treasury securities, the Federal Reserve’s System Open

Market Account. None came to fruition until 1969 when, faced with a sharp

increase in fails, dealers began to stretch out delivery times and declined to

enter into transactions for same-day settlement with anyone other than their

best customers. After the manager of the System Open Market Account

expressed concern that further degradation of the settlement process might

leave dealers reluctant to trade with the Federal Reserve for same-day settle-

ment, impairing its ability to achieve policy objectives, the Federal Open

Market Committee approved a modest securities lending program.

The 1969 program allowed lending of Treasury securities on a demand or

“tap” basis to primary dealers at a fixed fee of 75 basis points a year for up to

three business days. The program was not intended to be an instrument of


286

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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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.

TRIPART Y AND GENERAL COLLATERAL FINANCE REPOS

Repurchase agreements are crucial to the efficient allocation of capital in the

U.S. Treasury securities market, because they provide a low-cost way for deal-

ers to finance their marketmaking and risk-management activities. They also

provide a vehicle for mutual funds, corporations and municipalities to lend sur-

plus cash safely. The importance of the repo market is suggested by its immense

size: at the end of 2003 dealers with a trading relationship with the FRBNY—

so-called “primary”dealers—reported financing with repos an average of about

$2.5 trillion a day in Treasury and other fixed-income securities.

The simplest form of repurchase agreement is the deliver-versus-pay repo,

in which the borrower initially delivers securities to the lender against payment

of the principal amount of the loan. The lender then redelivers the securities

to the borrower against payment of interest and repayment of principal. In a

general collateral repo of this form, the securities must be drawn from a mutu-

ally acceptable class. Despite their widespread use, delivery-versus-pay repos

have several economically important transaction costs that arise from the

requirement that borrowers and lenders agree on the identity of the particu-

lar securities used as collateral, even though they may have no economic inter-

est in the securities’ identity at that level of specificity. In recent years market

participants have developed ingenious arrangements to suppress the effects of

this requirement, thereby achieving greater market efficiency.

Market and trading details In the “textbook” description of a general collateral repo, the dealer and lender

directly negotiate the principal amount, term and interest rate of the loan, as


288

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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Collateral specificity and transaction costsDelivery-versus-pay repos have several transaction costs related to collateral

specificity that limit their attractiveness. The first arises from the fact that a

dealer borrowing funds on a delivery-versus-pay repo must identify and com-

mit to deliver particular qualifying securities by about 11 a.m.27 This extinc-

tion so early in the day of the dealer’s delivery option can be costly in terms

of foregone opportunities for sale of securities already in the portfolio or expo-

sure to risk of delivery failure of securities it expects to receive later in the day.

In the event of a fail, the dealer usually can renegotiate delivery of different

securities in the acceptable class, but revising delivery instructions takes time

and adds cost.

Another cost arises from substituting collateral on a continuing term repo

when, for example, a dealer identifies an opportunity to sell the original col-

lateral at a favorable price. Collateral substitution requires two settlements, one

when the lender delivers the original collateral back to the dealer against pay-

ment and another when the dealer delivers the new collateral to the lender, also

against payment.28 Because the starting legs of interdealer repos must be set-

tled on a trade-by-trade basis, they are more costly than similar interdealer

trades that can be settled on a net basis. This limits the liquidity of the inter-

dealer market and, in turn, the liquidity of the broader dealer-institutional

lender market.

Triparty repoAs 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


290

services—receiving and transferring money and securities on behalf of

customers—can administer collateral programs at a lower cost by relying on

economies of scale and scope. Using triparty repos also limits credit exposure.

When an agent bank holds securities on behalf of a lender with a value in

excess of the lender’s claim, the lender is protected against the dealer’s default.

In addition, the dealer is simultaneously protected against the lender’s default

because the lender never takes possession of the collateral.

There are additional advantages if the agent bank is also the dealer’s clear-

ing bank. These arise from the ability of a clearing bank to transfer ownership

of a security between two custodial customers entirely on its own books with-

out Fedwire activity and from the willingness of lenders to rely on a clearing

bank to allocate dealer collateral to their custodial accounts. In a representa-

tive transaction, following the close of the securities Fedwire, the bank iden-

tifies qualifying securities that remain in the dealer’s clearing account and

allocates those securities to custodial accounts maintained for the benefit of

the various institutions that agreed to lend to the dealer. The allocation process

is structured to minimize the amount of unallocated collateral without vio-

lating any agreements regarding the class of mutually acceptable collateral.29

At the same time, the bank transfers the lenders’ funds to the dealer’s account.

This process postpones the time during the day that collateral is assigned to

lenders until well after the 11:00 a.m. time for assigning collateral on delivery-

versus-pay repos.

All the foregoing transfers are reversed the following morning, before the

8:30 a.m. opening of the securities Fedwire. If a dealer is committed to bor-

rowing on a continuing repo, the agent bank reinstates the dealer’s borrowing

commitment—and the lender’s loan commitment—immediately after the

morning reversal. Morning reversals of triparty repos are important because

they restore a dealer’s control over its collateral, giving it access to securities that

it might need to settle unrelated sales. The reversals also eliminate the costs

associated with specific collateral substitutions on an as-needed basis.

General collatoral finance repoTriparty repo is not readily applicable to interdealer repo trading, because it

does not preserve the mutual anonymity of borrowers and lenders and it is not

amenable to net settlement. In 1998 the FICC, in conjunction with the two

large clearing banks, JPMorgan Chase Bank and Bank of New York, intro-

duced a second innovation in general collateral repo. The new arrangement,

general collateral finance repo, was designed to reduce transaction costs and

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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


292

the morning reversal.32 Any additional commitments negotiated during the

day are added to, or subtracted from, the reinstated commitments in arriving

at the 3:45 p.m. calculation of each dealer’s net obligation to borrow or lend

that day. As with triparty repos, it can deliver entirely different securities—thus

suppressing the constraints of collateral specificity and achieving collateral

substitution in a transparent fashion.

NOTES

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 theRepublic of Korea are prominent as well. Not surprisingly, given that it is thelocation of a major global financial center, holdings reported for the UnitedKingdom, 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 inrecent 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 apremium. This practice was widely criticized for hindering direct sales of newissues to final investors and was believed to contribute to price volatility.

6. Conversely, setting overly generous terms on an exchange offer could causethe 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 notesin 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 bondsin July 1977, but removed the restriction again in August 1981, characterizing itas interfering with efficient adjustment of market prices.

9. Since 1916 the Treasury has used the 12 district Federal Reserve banks asits 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; providingfor denominational exchanges of government debt; and safekeeping collateralpledged against government monies held by private depositary institutions.

10. The Treasury would replace a lost or stolen bearer bond, but not until ithad matured and time had passed to allow the bond to be presented for payment.

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11. Treasury bills were never available in registered form because there wasso little demand for a short-term security that could not be transferred quickly.

12. The terminology derives from the fact that before 1941 the Commissionerof Public Debt (CPD) had to be notified of and approve every wire transfer of aTreasury 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 bydrawing on the inventory of bearer securities that it held as a fiscal agent of theTreasury. A bank with an obligation to deliver securities to FRBNY was essentiallyrunning an overdraft in its securities account at FRBNY. A bank had to agree thatas long as it ran an overdraft in a security it would retain possession of enough ofthat security in bearer form to settle the overdraft.

15. If a bank failed to deliver securities required to settle its position at theend of a business day, FRBNY could charge the bank’s reserve account for theprincipal amount of the securities. If the bank failed to deliver the securities onthe following business day as well, FRBNY could “buy in” the securities and chargethe bank for the cost of the buy-in. Additionally, each participant in theGovernment Securities Clearing Arrangement was obliged to indemnify FRBNYfor 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 withlarge holdings of Treasury securities—executes a repurchase agreement, lendingsecurities 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 borrowmoney. The fee is typically about the same as the contemporaneous specialnessspread for the security.

19. This cost may be reimbursed by the buyer, if the buyer’s actions causedthe 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 risearound mid-quarter refunding auctions, when market participants are activelyengaged 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 GovernmentSecurities Inc. failed in May 1982, when Hurricane Gloria disrupted New Yorkfinancial markets in 1985 and after the break in the stock market in 1987.


294

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 financedwith open or term borrowings.

23. Each participating dealer is told within minutes of the auction close whichof 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-averageloan fee for each security.

24. The late morning decline in liquidity became more pronounced duringthe second half of the 1990s, when dealers began financing their long and shortpositions earlier in the day following the imposition in 1994 by the Federal Reserveof charges for daylight overdrafts in the reserve accounts of depository institutionsand the prospect that dealer clearing banks would pass on such charges to theircustomers. This prompted the Federal Reserve to advance the time at which itenters the market to supply reserves to the banking system by lending on overnightrepos (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 andClearing Corporation (DTCC), which also owns the Depository Trust Company.The Government Securities Division of the FICC is the successor to theGovernment Securities Clearing Corporation (GSCC), which was acquired by theDTCC in January 2002. The GSCC was organized in the late 1980s to simplifythe settlement process for U.S. Treasury and federal agency securities, to reducethe volume of Fedwire transfers and to mitigate risk arising from counterpartyexposures 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 fornet settlement of transactions that settle on the day they are negotiated.

27. A borrower has to identify a particular security so the lender can instructits custodian to accept delivery of the security and to make the required paymentand because the lender subsequently holds that particular security during the termof the repo.

28. Bids and offers for money on term general collateral repos commonlyprovide 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 agiven 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 thecontemporaneous general collateral repo rate, as part of its clearing relationshipwith the dealer. Minimizing the amount of unallocated collateral also minimizesthe 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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JPMorgan Chase Bank can trade general collateral finance repo only with otherdealers that trade through JPMorgan Chase Bank; likewise, dealers that clearthrough Bank of New York, only with other dealers that clear through Bank ofNew York.

31. The aggregate net borrowing of all dealers who are net borrowers andclear through JPMorgan Chase Bank is identical to the aggregate net loan of alldealers who are net lenders and clear through JPMorgan Chase Bank, becauseevery general collateral finance repo transaction involves a borrowing and a loanof 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 totalpayments 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 theovernight repo rate.


296

EUROPEAN UNIONInstitutions 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

297

induced by mutual recognition or by a combination of both. EU integration

has thus built-in tendency to raise the quality of its institutions.

EU integration has prompted a learning process among member states

about best practice regulation. In striving for best practice, it has speeded up

the institutional reform process, especially in its peripheral economies. In the

same vein, EU enlargement is currently accelerating institutional reform in the

acceding countries and the new member states.

Against this background, the EU experience might be relevant to emerg-

ing market economies. The European Union’s striving for best practice regu-

lation to some extent is comparable with the standards and codes initiatives

in the international sphere. Just as internationally recognized standards and

codes have set a benchmark for good governance, so EU integration has pro-

vided benchmarks to its member states. A major difference, however, is that

the latter are binding on the member states. In addition, EU integration may

be regarded as a globalization process conducted at the regional rather than

the world level. The specific experience of the European Union with regional

integration might also provide some insights of broad relevance to emerging

market economies.

The focus of this study is on European experience with institution build-

ing in the financial sector, particularly in banking. Broader aspects of European

integration are reviewed only to the extent that they have been relevant to the

financial sector. This approach is warranted, since such major initiatives as the

Single Market Programme and the introduction of the euro did not necessar-

ily target (exclusively) the financial sector, but they have nevertheless had an

important direct or indirect impact on its working. After two major waves of

European integration, mostly addressing other areas (microeconomic policies

in the Single Market Programme and macroeconomic stability in the context

of the single currency), a new phase has started, with institution building more

directly related to supervisory and regulatory aspects in the financial sector.

OVERVIEW OF MAJOR INSTITUTIONAL CHANGES

Over the last 20 years institution building in the financial sector has been

driven mainly by two major developments in European integration: the estab-

lishment of the internal market and the establishment of the Economic and

Monetary Union. The focus of these two major waves of integration was not

the financial sector as such, but the free movement of goods, persons, services

and capital in the context of the Single Market Programme and macro-

economic stability in the context of Economic and Monetary Union. Both


298

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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and the respect and protection of minorities; the existence of a functioning

market economy, as well as the capacity to cope with competitive pressure

and market forces within the European Union; and the ability to take on the

obligations of membership, including adherence to the aims of political union

and of Economic and Monetary Union (EMU), namely the adoption of the

so-called acquis communautaire.4

In this respect, the integration of the accession countries into the Euro-

pean Union consists of two chronologically different steps. First is entry into

the European Union with the status of “member state with a derogation

to the adoption of the euro”, which implies that not all the legal provisions

of the treaty relating to the EMU are applicable. Second is the adoption of the

euro. Against this background, it has to be stressed that although most of the

aspects of financial integration relate to the European Union as a whole, some

elements to be discussed in the remainder of this case study concern only

countries, that have already adopted the euro.

The completion of the internal market (1985–92)Until the early 1980s financial markets in the European Union remained seg-

mented, not only across countries but also within countries, with extensive

regulatory constraints on the ability of banks and other financial intermedi-

aries to expand their activities beyond local markets and a narrow set of pre-

assigned product lines. The heavy regulation of financial activities in several

member states was acknowledged as a source of inefficiency in financial inter-

mediation, and a coordinated move toward liberalization was generally seen

as being required. However, it was realized that complete harmonization of

regulations was not workable, due to the wide variety of approaches followed

by national authorities.

In 1985 the European Commission published the White Paper on the

“Completion of the Internal Market” (often referred to as the “Single Market

Programme”), which suggested how to make progress in the removal of exist-

ing barriers to the creation of an internal market to achieve the free movement

of goods, persons, services and capital by the end of 1992. The 1985 White

Paper also presented a new strategy of institution building: the reliance on

the principle of mutual recognition coupled with a minimum level of har-

monization in key regulations.5

For financial services, mutual recognition under this new method of inte-

gration implied that financial institutions would have the right to conduct busi-

ness in the whole European Union under a single national license, being subject


300

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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of national banking sectors across the European Union. However, complete

freedom of capital and current account payments was achieved only in January

1994. Full liberalization of capital movements within the Community, and with

third countries, has since been enshrined in the Treaty on European Union.

The creation of the single currency (1992–99)The 1992 Maastricht Treaty confirmed the Single Market Programme and

decided on the gradual creation of a single currency. It laid out a three-phase

transition period for the introduction of the euro, leading eventually to the

irrevocable fixing of exchange rates on 1 January 1999 and the introduction

of euro banknotes and coins on 1 January 2002 in member states that com-

plied with the institutional framework established in the Treaty and were will-

ing to commit themselves to the EMU.6

The introduction of the euro also implied new institutions and rules for

the member states, mainly related to monetary and fiscal policies. The EMU

can be seen as a system of rules aimed at attaining and maintaining macro-

economic stability. Such a system was bound to have a bearing on the devel-

opment and integration of financial markets within the monetary area. So,

while the Maastricht Treaty did not alter the regulatory and supervisory frame-

works for financial markets—regulatory and supervisory powers remained

with national authorities—the treaty provisions relating to the EMU have had

direct or indirect implications for financial markets.

The most obvious innovation of the EMU was the establishment of the

European Central Bank (ECB) and the transfer of competence for monetary

policy to the Eurosystem, comprising the ECB and the national central banks

of the member states having adopted the euro, with the primary objective of

achieving and maintaining price stability.7 Another new element is that the

Eurosystem is asked to contribute to the smooth conduct of national policies

in the fields of prudential supervision and the stability of the financial system,

notwithstanding the competence of national authorities in that area.8

The institutional setup of monetary union also required procedures at

the EU level for coordinating economic policies as well as for monitoring fis-

cal policies. The latter reinforced through the establishment of enhanced rules

for budgetary discipline, incorporated into the “Stability and Growth Pact”

endorsed by all EU member states before the start of the EMU. To join the

EMU, countries have to meet the convergence criteria related to fiscal policies;

it was felt that there was a need to ensure that all EU members states, irre-

spective of whether they have adopted the euro, continue pursuing sound


302

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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SOME ST YLIZED FACTS ON THE IMPACT ON FINANCIAL SECTOR

DEVELOPMENT

The Single Market and the launch of the euro in 1999 modified the institu-

tional framework under which financial markets operate in the European

Union in ways that boosted the integration of financial markets. The new

institutional framework established with the advent of the single currency will

undoubtedly continue to have an impact on the structure of the euro area

economy in the years to come.

From a theoretical viewpoint, financial integration can be expected to

enhance the development of financial systems and to improve economic per-

formance.9 Empirically, the benefits from financial integration are difficult to

disentangle from other factors. But integration is likely to enhance the over-

all performance of the EU financial system through two main channels: first,

the exploitation of the scale and scope effects inherent in financial activity, and

second, increased competitive pressure on financial intermediaries.

Looking at the effects on individual countries in an integrating area, finan-

cial integration is likely to spur the efficiency of financial intermediaries and

markets in less financially developed countries. To the extent that this greater

efficiency stimulates the demand for funds and for financial services, this

should also translate into larger domestic financial markets. A second reason

for financial integration to be associated with local financial development is

that the process of integration generally requires better national regulation

(accounting standards, securities law, bank supervision, corporate governance

and the like) to bring local financial development into line with best practice

regulation in the integrating area. Convergence toward a level playing field in

regulation may improve the regulatory standards of less developed financial

markets.

Financial integration has important implications for financial stability.

As discussed above, financial integration should contribute to the develop-

ment of financial systems, thus making them more resilient to potential

shocks. But new vulnerabilities may arise, because intensified competition

among financial institutions tends to erode profit margins and may induce

individual institutions to restore profitability by accepting higher-risk expo-

sure. In addition, cross-border activities by the banks themselves, and inter-

national economic and financial links in general, can lead to contagion effects,

transmitting a foreign financial crisis to the domestic financial system. The

European Union is looking into the challenges brought about by financial

integration for the regulatory and supervisory arrangements.


304

As for the development and degree of integration in the different finan-

cial markets, the following stylized facts provide a broad picture:

• The liberalization process in the banking sector has increased competi-

tion, which has induced a trend toward consolidation, highlighted by

a continuous decline in the number of banks and growing merger and

acquisition activities. With the introduction of the euro, cross-border

activities increased significantly. Wholesale banking markets have

become substantially more integrated across the European Union, and

wholesale banking today operates as an EU market rather than in dis-

tinct national markets. But the retail banking sector is less integrated,

owing partly to the fact that proximity to customers is a decisive fac-

tor for a number of products. While there are still significant differ-

ences in lending and deposit margins across the euro area, some

convergence can be observed, mainly in household lending margins.

• In the euro area money market the unsecured lending market exhib-

ited a high level of integration immediately after the euro’s intro-

duction, illustrated by the very small spread in unsecured lending

rates across individual euro area countries. A market segment of par-

ticular interest to the ECB, owing to its role in implementing mone-

tary policy, is the market for unsecured overnight lending, where a

high degree of integration also prevails. Other segments, such as the

repurchase agreement (repo) and short-term securities markets, still

have some way to go before reaching a similar level of integration. The

continued fragmentation in these segments reflects difficulties in

integrating the securities market infrastructure in such a way that

collateral can be used smoothly and swiftly on a cross-border basis in

the euro area. The Eurosystem has already taken steps, in cooperation

with EU securities regulators, to ease these obstacles to a better inte-

grated and more efficient secured money market.

• Integration in the government bond market is already well advanced.

Spreads of 10-year euro area government bonds relative to German

bonds have fallen continually since the mid-1990s and have become

very small already since 1998. It seems that the euro has also played

a role in stimulating the development of the corporate bond market.

• Equity markets also show signs of deepening integration, as the

performances of the various euro area equity markets are gradually

determined by events common to all investors and less by country-

related factors. Indeed, euro area institutional equity investors have

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for some years based their asset allocation strategies on industry and

sector considerations, not on national considerations.10

FURTHER STEPS IN INSTITUTION BUILDING

A number of structural trends have begun to affect the European Union’s

financial landscape after the introduction of the euro. The most important

structural changes in EU countries include consolidation in the banking sec-

tor, intensified competition, internationalization of financial activities within

and outside the European Union as well as the new establishment of mixed

financial groups and conglomerates. While some of these changes started ear-

lier, the introduction of the euro has further intensified such changes with the

increasing integration of capital markets and closer links between financial

institutions in the euro area.

Since the onset of the EMU, therefore, financial regulators and supervisors

in the European Union have been confronted with a rapidly evolving environ-

ment and a two-fold challenge in particular. First is to update the EU financial

rulebook to keep pace with financial market developments and to improve reg-

ulatory and supervisory convergence across member states. Second is to

strengthen cross-border cooperation in the areas of prudential supervision,

financial stability and crisis management.

Modernizing the EU financial rulebook and improving regulatory andsupervisory convergenceAfter the introduction of the single currency EU member states realized that

the remaining legislative, administrative and fiscal barriers to cross-border

financial transactions were seriously hampering the reaping of the full bene-

fits from monetary integration. At the same time, they considered that the EU

financial rulebook was not sufficiently flexible to be adjusted to rapidly unfold-

ing financial market developments and financial innovation. Both problems

were especially prominent in the securities sector, where the protection of local

investors hampered the workability of the mutual recognition principle. The

two major steps to address these shortcomings have been the adoption of the

Financial Services Action Plan and the implementation of the Lamfalussy

framework for financial regulation. Both measures also aim at achieving the

regulatory and supervisory infrastructure that could underpin a truly inte-

grated market for financial services in the European Union.

The Financial Services Action Plan was launched in May 1999, and sets

out a detailed program of 43 legislative initiatives covering most areas of the


306

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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Supervisors has also been established to ensure consistent implemen-

tation of legislation and advise the commission in the field of insur-

ance and pension schemes.

• At level 4 the EU Commission would verify the compliance of mem-

ber state laws with EU legislation to strengthen the enforcement of

Community legislation within member states.

The Lamfalussy framework is already being applied to securities market

legislation.

In December 2002 the Council of Economic and Financial Ministers

endorsed the Economic and Financial Committee’s report on “EU Arrangements

for Financial Regulation, Supervision and Stability” in Europe, which proposed

extending the Lamfalussy framework to banking, insurance and pension funds

and to financial conglomerates. The European Union is currently setting up the

infrastructure of regulatory and supervisory committees for these sectors.

Strengthening cooperation for financial stability and crisis managementWith the onset of the EMU, euro area–wide systemic risks have grown in

importance. Deeper financial integration reduces risks of financial instability

in the sense that the financial system can more easily absorb potential shocks.

But new sources of vulnerability have emerged, such as the exposure of domes-

tic banking sectors to common shocks and the increased risk of cross-border

contagion. This prompted the European Union to undertake a thorough review

of the existing arrangements for financial stability and crisis management

within the euro area. As a result of this process, the Economic and Financial

Committee adopted two reports, the first on financial stability (April 2000)

and the second on financial crisis management (April 2001), known as the

“Brouwer Reports I and II”. These were subsequently endorsed by the Council

of Economic and Finance Ministers.

The two reports highlighted the challenges for European cooperation in

financial stability and crisis management and made two recommendations.

First, the exchange of information and the cooperation between supervisory

authorities and central banks should be enhanced, irrespective of the roles of

central banks in financial supervision at the national level. This involvement

of central banks acknowledges their specific expertise in the area of financial

stability and their composite nature as both members of the Eurosystem and,

at the same time, national institutions. Closer cooperation and exchange of

information would be required in particular with a view to macro-prudential

and structural monitoring of financial market developments, as well as in the


308

area of financial crisis management. Second, cross-sector cooperation at the

European level should be strengthened to respond to the greater integration

of financial products, markets and intermediaries across the traditional

boundaries of the banking, securities and insurance sectors.

The European Union has already taken steps to implement these recom-

mendations. To address the need for closer cooperation between central banks

and supervisors, the work of the Banking Supervision Committee, the forum

for cooperation between central banks and banking supervisors within the

Eurosystem, has been stepped up.

With a view to strengthening cross-sectoral cooperation, the European

Union has established an informal Cross-Sector Roundtable of Regulators, a co-

ordinating forum for all EU sectoral regulatory and supervisory groups. Cross-

sectoral issues of financial regulation and supervision are also addressed by the

Financial Services Committee (the reconfigured Financial Services Policy Group),

which has been directed to provide strategic guidance on financial sector policies.

The regulatory and supervisory implications stemming from the emergenceof large and complex financial institutionsThe consolidation in the financial industry and the erosion of boundaries

between financial sectors have given rise to large and complex financial insti-

tutions, which operate both on a cross-border and a cross-sectoral basis. Given

that the behavior of large and complex financial institutions is likely to affect

money and capital markets as well as payment and settlement systems, ade-

quate monitoring of the financial risks for such institutions is highly impor-

tant from a systemic stability point of view. This creates the five challenges for

regulators and supervisors:

• Large and complex financial institutions typically include regulated

entities subject to different supervisory authorities within each mem-

ber state or undertakings based in different member states. Therefore,

a high degree of coordination between all authorities involved is nec-

essary and requires measures to facilitate the exchange of information

among supervisors and the appointment of a coordinating supervi-

sory authority.

• Sectoral community legislation should be amended to ensure a level

playing field between financial conglomerates and financial groups

that are engaged in just one sector of the financial market or a single

country, as well as to reduce the incentives for regulatory arbitrage

within large and complex financial institutions.

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• Capital adequacy regulation and supervision concerning large and

complex financial institutions involve specific issues, such as addressing

the risk of double gearing and excessive leveraging as well as monitor-

ing intragroup transactions and large exposures.

• Large and complex financial institutions should meet more advanced

organizational requirements, such as highly sophisticated internal

risk management and control mechanisms to address possible con-

flicts of interest within the institution.

• To ensure adequate market discipline, a high level of transparency

and disclosure on the part of large and complex financial institutions

needs to be ensured.

To address these issues, the European Union introduced, in 2002, a new

piece of Community legislation, the Financial Conglomerates Directive. In

addition, a new EU committee on regulatory issues regarding financial

conglomerates was established earlier this year.

POLICY 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

and public sector cooperation—can help small emerging economies benefit

from well functioning regional financial markets. Many emerging market

economies are small countries—with small financial systems. They tend to

underperform because they suffer from a concentration of risks and low liq-

uidity. And the smaller the financial system, the more vulnerable it is to exter-

nal shocks, and the more difficult it is to insulate it from or hedge it against

those shocks, unless it is itself fully integrated into the world financial system.

Such integration might, however, be a dangerous route if not well sequenced.

Thus, financial integration on a smaller, regional scale can help to deepen and

broaden domestic financial systems without exposing them to the same risks.

The European experience also shows that the institutional underpinnings

of financial markets are never complete and that new challenges and oppor-

tunities surface constantly. Regulators and governments must take opportu-

nities as they arise, and there is only a limited amount of reform that can be

implemented at one point in time. This study has exemplified that institution

building is essentially an iterative process. It has shown that the major initia-

tives like the Single Market Programme and the introduction of the euro did

not target primarily the financial sector, but nevertheless had an important

direct or indirect impact on its working. The Single Market Programme was

mainly concerned with the micro infrastructure for the free movement of

goods, persons, services and capital, whereas the Treaty provisions related to

the EMU aimed mainly at macroeconomic stability. Both initiatives con-

tributed to a market-driven process of increased integration in financial mar-

kets and of structural changes, such as increased competition, concentration

and the establishment of mixed financial groups.

This market-driven process has, in turn, prompted a new phase of insti-

tution building. Following the introduction of the euro, which left national

competencies for supervisory and regulatory unchanged, EU member states

have realized the need to improve supervisory and regulatory convergence

between themselves and to strengthen cross-border cooperation in financial

stability and financial crisis management.

The European experience confirms that institution building in the finan-

cial sector and in the broader macroeconomic policy need to go hand in hand

and be consistent. A well functioning and sound financial system is precondi-

tioned on a stable macroeconomic policy framework, which in the European

case builds on central bank independence and rules for budgetary discipline.

Likewise, deregulation and enhanced competition in the financial system gen-

erate pressures for reforming the underlying monetary and fiscal framework in

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order to minimize policy-generated shocks. This interrelationship between

financial sector and macroeconomic policies implies that reforms in either

sphere need to be coordinated at an early stage—to reap the potential synergies.

NOTES

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 successivewaves of new members joining the European Community. Nine countries haveso far joined the six founder members—Belgium, France, Germany, Italy,Luxembourg and the Netherlands—at the following dates: Denmark, Ireland andthe 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 theentire continent of Europe. It is an unprecedented enlargement in terms of itsdimension and diversity. As of 1 May 2004, 10 countries from Central and EasternEurope—the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slo-vakia and Slovenia—as well as two Mediterranean countries—Malta andCyprus—have joined the EU. As far as Bulgaria and Romania are concerned, thegoal is to enable them to join by 2007. Negotiations might be opened with Turkeyin 2005 if the country has fulfilled the political part of the Copenhagen criteria (seehttp://europa.eu.int/scadplus/leg/en/cig/g4000a.htm#a11).

4. The acquis is the body of common rights and obligations that bind all themember states together within the European Union. It is constantly evolving andcomprises: the treaties, Community legislation, the case law of the Court of Justice,the declarations and resolutions adopted by the Union, measures relating to thecommon foreign and security policy and to justice and home affairs and interna-tional agreements concluded by the Community and by the member statesbetween 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 EuropeanCourt 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 entryinto other member states, unless restrictions are necessary in order to satisfymandatory requirements (for example, the effectiveness of fiscal administration,the protection of public health, the fairness of commercial transactions, consumerprotection and environmental protection). Harmonization henceforth wouldfocus 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 UnitedKingdom. While Denmark, Sweden and the United Kingdom decided for politicalreasons not to join the EMU at this point, Greece was unable to join as it did not


312

meet all the convergence criteria. On 1 January 2001 the euro was introduced inGreece, following a report by the ECB and the EU Commission that Greece had thenfulfilled 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 andmanage 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 tasksto the ECB in the area of prudential supervision of credit institutions and otherfinancial institutions with the exception of insurance undertakings. This optionhas, however, so far not been used.

9. Financial development can affect growth through three channels: it canraise the proportion of savings channelled to investment through the reductionof the costs of financial intermediation, it can improve the allocation of resourcesacross investment projects, thus increasing the social marginal productivity ofcapital, and it can influence households’ saving rate. While in the first two casesthe effect on growth is generally positive, in the third the direction of the effect isambiguous (Pagano 1993).

10. See European Central Bank (2001).

11. See Committee of Wise Men on the Regulation of European SecuritiesMarkets (2001).

REFERENCES

Acemoglu, D. 2003. “Root Causes—A Historical Approach to Assessing the Roleof Institutions in Economic Development.” Finance and Development 40 (22):27–30.

Adjaouté, K., and J.-P. Danthine. 2003. “European Financial Integration andEquity 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. “MeasuringFinancial Integration in the Euro Area.” Occasional Paper 14. EuropeanCentral Bank, Frankfurt, Germany.

Barr, D.G., and R. Priestley. 2002. “Expected Returns, Risk and the Integration ofInternational Bond Markets.” Journal of International Money and Finance23(1): 71–97.

Committee of Wise Men on the Regulation of Securities Markets. 2001. “FinalReport of the Committee of Wise Men on the Regulation of SecuritiesMarkets.” Council of the European Union, Stockholm.

EUROPEAN UNION

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De Avila, D.R. 2003. “Finance and Growth in the EU: New Evidence from theLiberalization and Harmonization of the Banking Industry.” ECB WorkingPaper 266. European Central Bank, Frankfurt, Germany.

Devereux, M., and G. Smith. 1994. “International Risk Sharing and EconomicGrowth.” 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, 17September, Amsterdam.

European Central Bank. 2001. “The Euro Equity Market.” Frankfurt, Germany.

———. 2003. “The Integration of the European Financial Markets.” MonthlyBulletin, October. Frankfurt, Germany.

EU Commission. 2001. “Financial Market Integration in the EU.” In The EUEconomy Review. Brussels. [http://europa.eu.int/comm/economy_finance/publications/european_economy/2001].

———. 2003. “Tracking EU Financial Integration.” Commission Staff WorkingPaper 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 PolicyResearch, 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 FinancialSystem: Structure, Integration and Policy Initiatives.” Oxford Review ofEconomic 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.” EuropeanEconomic Review 37 (2–3): 613–22.

Pelkmans, J. 1997. European Integration—Methods and Economic Analysis. Oxford,U.K.: Oxford University Press.


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FINANCIAL SECTOR STANDARDS

AND CODES AND INSTITUTION

BUILDING

PREPARED BY THE INTERNATIONAL MONETARY FUND

A well functioning financial sector is essential for economic development. But a

robust financial sector needs an effective institutional infrastructure. Sound insti-

tutions contribute to macroeconomic and financial stability, financial deepening

and greater and more stable international capital flows.1 Together with efficient

markets, they reduce the likelihood and magnitude of a financial crisis.

The International Monetary Fund (IMF) has a long history of helping

member countries develop institutional capacity in the financial sector. This

assistance has traditionally concentrated on central banking and developing

markets to support effective monetary and exchange rate policies. The finan-

cial crises of the 1990s led the IMF to address other aspects of institution build-

ing. In particular, the joint IMF–World Bank Financial Sector Assessment

Program (FSAP), introduced in May 1999, was developed as an important

diagnostic instrument for identifying risks, vulnerabilities and development

priorities in the financial sector.

FSAPs focus on strengthening markets and institutions and supporting

best practices that promote financial stability. They are a key element in the

international community’s efforts to strengthen the international financial

architecture and prevent crises. Standards assessments in FSAPs are under-

taken in cooperation with other institutions and rely on methodologies devel-

oped by standards-setting bodies.

This chapter summarizes the IMF’s experience with the assessments of

financial standards and codes and their role in institution building.2 While it

is premature to judge the full impact of the standards assessments, experience

and feedback from participating countries so far point to positive contribu-

tions to crisis prevention and financial stability from stronger supervisory and

regulatory frameworks, better transparency in monetary and financial poli-

cies and more capacity for assessing risk. These derive from the identification

315

of key institutional weaknesses and provision of follow-up technical assis-

tance. At the same time, developing standards and codes and finding ways to

enhance national authorities’ ownership of needed reforms continue to be

important for institutional reform. Recent IMF work has focused on gaps in

the regulatory frameworks and the coverage of codes and standards to iden-

tify areas where they need to be enhanced.3

HOW STANDARDS ASSESSMENTS BY FSAPS STRENGTHEN THE

INSTITUTIONAL INFRASTRUCTURE OF THE FINANCIAL SECTOR

The institutional infrastructure needed to support financial development has

been characterized as encompassing “software” and “hardware”. Laws, regula-

tions and procedures constitute the essential institutional software, and orga-

nizational arrangements and market structures are the requisite hardware.

The standards and codes assessed by FSAPs embody widely accepted princi-

ples of institutional development and reflect a broad conception of institu-

tional requirements, covering legal, regulatory and supervisory frameworks,

functioning of markets, organizational arrangements for supervising subsec-

tors, transparency of policies and organizations, adequacy of related resources

and the like. Standards are based on widely accepted practices from a range of

experience that contribute to sound and stable institutions.

Recent research has highlighted how compliance with standards and codes

contributes to a more stable financial system. A paper by Podpiera (2004) esti-

mates a model of banking system asset quality using panel data for 65 coun-

tries that have had Basel Core Principles assessments and finds that an

assessment is associated with a statistically significant improvement in asset

quality. A related paper by Das and others (2004) tests for the contribution of

regulatory governance to financial stability. The quality of regulatory gover-

nance is measured using information from four key codes and standards assess-

ments. Specifically, an index is constructed from the rates of compliance with

specific governance criteria in the Basel Core Principles, the monetary and

financial policy transparency code, the Insurance Core Principles and the

International Organization of Securities Commissions Core Principles cover-

ing securities markets. Model estimates derived from a panel of data covering

50 countries indicate that regulatory governance makes a statistically signifi-

cant contribution to financial stability.4 Overall, these empirical studies provide

evidence that the quality of institutions is important for financial stability.

Financial sector standards are designed to provide general guidance while

allowing sufficient flexibility to take into account individual country


316

circumstances and needs. It is well understood that institutional design and

reform are heavily influenced by country- and time-specific considerations.

Indeed, high levels of income and wealth have been achieved under a variety

of institutional structures, reflecting different legal and regulatory approaches

and degrees of state involvement in the economy. Internationally accepted

practices, therefore, are likely to be only a reference point or benchmark for

specific institutional reforms.5 Standards assessments are aimed mostly at

identifying systemic weaknesses and should not be viewed as instruments for

preventing failure of individual institutions.

Standards assessments are most helpful when undertaken in the proper

context. The comprehensive scope of an FSAP provides a meaningful setting

in which to assess financial sector standards by taking into account the broader

macroprudential environment and related risks and by drawing inferences

about the broader implications of financial stability. FSAPs often evaluate

other relevant standards and practices that affect the quality and integrity of

institutions—such as corporate governance, insolvency regimes and account-

ing practices. Comparing individual country practices with accepted interna-

tional benchmarks also helps ensure the quality and consistency of assessments

by basing them on standardized methodologies and templates. An intensive

review process also helps provide consistency and a cross-country perspective.

By end-October 2004, 348 assessments of standards and codes had been

conducted under the FSAP. These include 76 Basel Core Principles, 61 Core

Principles for Systemically Important Payment Systems, 45 International

Association of Insurance Supervisors Core Principles, 50 International

Organization of Securities Commission Principles, 68 IMF Code of Good

Practices on Transparency in Monetary and Financial Policies and 36 Anti-

Money Laundering and Combating Financing of Terrorism standards.

Standards assessments completed in the context of FSAPs have been most

useful for identifying gaps and setting priorities for institutional reform. The

assessments have also provided a context for judging the relative importance

of institutional deficiencies. For instance, FSAP missions have attempted to

differentiate between appropriate legal frameworks (laws and regulations) and

implementation. As a result, closing the gap between “laws on the books” and

implementation is a developmental priority in many cases, and follow-up work

should focus on enhancing judicial competence, efficiency and independence.

The assessments also help sequence institutional reform by setting the

diagnosis in a broader macroprudential context. Measures to reinforce stability

are given immediate attention, while developmental needs are addressed over

FINANCIAL SECTOR STANDARDS AND CODES AND INSTITUTION BUILDING

317

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.

MAIN FINDINGS FROM STANDARDS AND CODES ASSESSMENTS

FSAPs are selective in terms of assessed standards, and the diagnosis of weak-

nesses across countries has varied accordingly. In many developing countries

a range of concerns need to be addressed over the medium term, including

banking supervision, legal and regulatory frameworks for banks and non-

banks, payment systems, systemic liquidity management and arrangements

for bank restructuring. At the same time, several emerging economies, hav-

ing recovered from financial crisis, have achieved a good degree of compli-

ance in banking supervision and regulation. Their deficiencies are related to

the ability of supervisory authorities to keep up with proliferating financial

services, undertake risk-based supervision, take prompt corrective action,

deal with consolidated supervision and cooperate with other domestic and

foreign supervisory agencies. Although the assessments for some industrial-

ized countries indicate a high degree of compliance with international stan-

dards and codes, they also reveal challenges from regulatory gaps in areas

related to the trend toward global conglomeration of their financial


318

institutions, including electronic banking, the role of state banks, reinsur-

ance and loan classification systems.

Assessments of compliance with the Basel Core Principles identified sev-

eral areas where better compliance could build sounder institutions. In par-

ticular, compliance with best practices for credit policies and connected

lending is weak, and poor lending practices are a serious threat to banking sta-

bility in many developing countries. The assessments also found that loan

evaluation and loan provisioning tend to be weaker in practice than on paper,

and exchange rate, interest rate and other market and country risks tend to be

underestimated. In addition, when the supervisory authority lacks full inde-

pendence, enforcement of remedial measures against weak banks is barely

effective, even when regulations contain the relevant provisions. Another area

requiring attention is supervision of large and complex financial institutions,

particularly for consolidated supervision and consolidation of accounts.

The assessments of the Core Principles for Systematically Important Pay-

ment Systems found a high degree of compliance in industrialized economies

and, to a large extent, also in transition economies. In developing countries a

significant majority of the payment systems have design and operational lim-

itations that expose them to certain risks. These countries often have difficulty

managing credit, liquidity and other risks, which leaves the system unprotected

against an insolvent participant. Other deficiencies include legal frameworks,

rules and regulations pertaining to payment systems and security of operating

systems. But the amount of funds channeled through these systems in devel-

oping countries is less than it is in industrialized countries, and several coun-

tries are now modernizing their payment systems.

The assessments of the International Association of Insurance Supervisors

Insurance Core Principles highlighted limitations on the preconditions for

effective insurance supervision, such as appropriate accounting and actuarial

practices and internationally acceptable standards for capital. Other common

weaknesses related to the proper organization of the insurance supervisor and

adequate supervisory skills, criteria for denying changes in control of institu-

tions, corporate governance and internal controls, adequacy of prudential

rules on investment and exposure limits, the adequacy of the supervisors’

power to review or set standards for the use of reinsurance by direct-writing

companies, market conduct and a complaint-handling system and rules for the

use of derivatives and disclosures. Although these deficiencies do not appear

to pose serious systemic risks, the insurance sector is exposed to equity risks

from guarantees given to the banking sector (including credit and mortgage


319

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


321

BOX 1

OBSERVANCE OF TRANSPARENCY IN MONETARYAND FINANCIAL POLICIES

Assessments of observance of the IMF’s Code on the Transparency ofMonetary and Financial Policies have highlighted several weaknessesin monetary policy, including lack of:

• Clarity of roles, responsibilities and objectives of central banks—ageneral lack of clarity in monetary policy objectives, responsibilityfor foreign exchange policy, legal provisions on disclosure,accountability and institutional relationship with other govern-ment agencies.

• Open process for formulating and reporting monetary policydecisions—inadequate explanation of the rationale and function-ing of monetary policy instruments and the frequency andsubstance of disclosure.

• Accountability and assurances of integrity by the central bank—deficiencies in auditing and accounting procedures, disclosure ofinternal governance procedures and legal protection for officialsand staff in the conduct of their official duties.

Many economies have responded positively to rectifying theweaknesses highlighted in the transparency assessments.

Hong Kong (China)Financial supervision. The responsibilities delegated to top financeofficials, including the financial secretary and secretary for financialservices and the treasury were clarified, with policy formation andexecution responsibilities clearly separated. A formal statement ofmonetary policy aims that include exchange rate stability maintainedby the Hong Kong Monetary Authority (HKMA) was also released.

Insurance regulation. The Insurance Authority and the HKMAsigned a memorandum of understanding outlining their respectiveresponsibilities for regulating banks’ insurance business. The HKMAis responsible for the daily regulation of banks’ insurance business.For complaints of malpractice, the two regulators share investigativework and take disciplinary action as needed.

Banking supervision. Annual disclosure requirements wereupdated to include analysis of investments in securities, and interimdisclosure requirements were updated to include balance sheet infor-mation and further analysis of off–balance sheet exposures. Disclosurerequirements were updated for some institutions to include overdueand rescheduled loans as well as exposure to derivatives and contracts.

transition economies), key weaknesses still remain, particularly for Combating

the Financing of Terrorism. In most cases, the authorities have set compliance

with the Financial Action Task Force’s standards as a key priority and are in the

process of improving their systems to comply with those standards. Even so,

implementation is often hindered by the lack of skills, budgetary resources and

legal and financial sector infrastructure. The observations of the vulnerabili-

ties in the Anti-Money Laundering and Combating Financing of Terrorism

regimes are reflected in intensified IMF–World Bank technical assistance.

INSTITUTION BUILDING THROUGH FSAP FOLLOW-UPS

AND TECHNICAL ASSISTANCE

Standards assessments usually result in recommended actions with an indi-

cation of priority. This provides a basis for follow-up by the relevant author-

ities that can be supported by technical assistance from the World Bank and

the IMF. In several cases the authorities have indicated that the recommen-

dations helped them formulate their own policy priorities.

Many countries have requested technical assistance for implementing the

FSAP recommendations and bolstering institutional capacity. The assistance

already provided spans a range of areas, including monetary policy imple-

mentation, supervision and regulation of banking, insurance and capital mar-

kets, unified supervision, Anti-Money Laundering and Combating Financing

of Terrorism legislation and implementation, payment system reform, legal

reform, sequencing of capital account liberalization, public debt management,

inflation targeting and bank restructuring.

For insurance, follow-up technical assistance has covered insurance legisla-

tion, regulation and organization of a supervisory body. For securities market


322

BOX 1 CONTINUED

RussiaMonetary policy. The 1999 annual financial statement was publishedwith more detailed information on the relationship between the Bankof Russia and the Ministry of Finance, central bank income andexpenditure and new information on its capital, funds and profit dis-tribution. The most important measure was preparing the annualfinancial statement in compliance with international standards.Precious metals transactions and government securities, however, arestill valued at acquisition cost.


323

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.

FURTHER STRENGTHENING THE ROLE OF STANDARDS ASSESSMENTS

Close cooperation with standards-setting agencies and adherence to assess-

ment methodologies and guidance notes are improving consistency in stan-

dards assessments. These assessments are also helping to identify regulatory

gaps. In increasingly integrated financial systems, cross-sectoral and cross-

country regulatory issues are becoming more important. Steps have also been

taken to strengthen the post-assessment review process. The IMF has estab-

lished a roster of external reviewers in the banking, insurance, payment and

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.

NOTES

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 ratioand the ratio of nonperforming loans to total loans.

5. See IMF (2003).

6. For details, see Calari and Ingves (2003).

REFERENCES

Calari, C., and S. Ingves. 2003. “Financial Sector Assessment Program—Review,Lessons, and Issues Going Forward.” Including supplements. IMF WorkingPaper 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.” IMFWorking Paper 04/89. International Monetary Fund, Washington, D.C.

IMF (International Monetary Fund). 2003. “Growth and Institutions,” In WorldEconomic Outlook. International Monetary Fund, Washington, D.C.


324

———. 2004. “Financial Sector Regulation: Issues and Gaps.” InternationalMonetary Fund, Washington, D.C.

Podpiera, Richard. 2004. “Does Compliance with Basel Core Principles Bring AnyMeasurable Benefits?” IMF Working Paper 04/204. International MonetaryFund, Washington, D.C.

Prasad, E., K. Rogoff, S. Wei, and M. Kose. 2003. “Effects of Financial Globaliza-tion on Developing Countries: Some Empirical Evidence.” IMF OccasionalPaper 220. International Monetary Fund, Washington, D.C.


325

THE EVOLVING INSTITUTIONAL

AGENDA FOR SOUND FINANCE

PREPARED BY THE WORLD BANK

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 institutional underpinnings of finance have stimulated research on the

links between finance and institutional issues.

The understanding of the institutional agenda for sound finance is still

evolving. The World Bank has been contributing to this debate through its

research and policy work, but it has also greatly stepped up efforts to assist

developing countries in strengthening the policy and institutional founda-

tions of their financial sectors.

INSTITUTIONAL UNDERPINNINGS FOR SOUND FINANCE

Few now doubt the link between finance and growth, but crises and the rise

of the new institutional economics have turned attention to how countries can

secure the positive effects of financial sector development while avoiding the

dangers.1 Heightened interest in the role of institutions in economic devel-

opment started with the path-breaking articles by La Porta and others (1997,

1998, 2000) on the importance of legal factors as key institutional variables for

economic development. Their research found that such factors as the protec-

tion of creditor and shareholder rights are key to the development of the finan-

cial sector and to growth. Almost simultaneously, research on geography and

its role in economic development was given impetus by Diamond (1997), and

a debate began as to the relative importance of institutional and geographical

factors. More recent research (Easterly and Levine 2003; Beck, Demirgüç-Kunt

and Levine 2003; Rodrik, Subramanian and Trebbi 2004) shows that both

geography and institutions matter for growth and financial sector develop-

ment, but that once one accounts for the impact of geography on institutions,

geographical factors cease to matter.

Following the East Asian crisis, there was considerable focus and work on

the core attributes of a well functioning financial system that would reduce the

likelihood of problems and be more resilient to financial instability. This led

to the enunciation of 12 core standards by the Financial Stability Forum, 10

of which pertain to the financial sector and related market infrastructure. An

important subset of these pertains to financial market regulation, which is

reviewed in the chapter by the International Monetary Fund (IMF), and is

assessed by the Bank and the IMF through the joint Financial Sector

Assessment Program (FSAP). A well functioning financial system also requires:

the provision and communication of information, the exercise of corporate

governance (that defines the extent of power of insiders vis-à-vis external

providers of finance) and ultimately the ability of the system to provide funds

with appropriate risk taking. The provision of reliable information, the exer-


327

cise of corporate governance and ultimately appropriate risk-taking rest on

deeper institutional foundations, some of which pertain only to the financial

sector and some of which are economywide. Of these, there are three of cen-

tral importance: accounting and auditing standards and practices; legal frame-

work and practices, including those for insolvency and corporate governance;

and incentive-compatible prudential regulation and supervision.

The review of the institutional agenda in the remainder of this chapter

focuses on three important institutional pillars where the Bank has been play-

ing an important role: legal infrastructure, including insolvency regimes;

accounting and auditing practices; and corporate governance. The final section

reviews the Bank’s support for institution building in the financial sector.

LEGAL INFRASTRUCTURE FOR FINANCIAL SYSTEMS

The legal infrastructure plays a critical role in supporting the operation of

financial markets and the efficient intermediation of capital flows and domes-

tic savings. Financial institutions hold claims on borrowers, the value of which

depends on the certainty of legal rights and the predictability, speed and fair-

ness of their enforcement. The legal framework empowering and governing

the regulator and the rules for the regulation of the various markets are the

cornerstone for orderly development and functioning of financial markets. In

this respect the key laws are those governing the formation and operation of

supervisory bodies such as the central bank and the laws regulating banking

and financial institutions. In addition, the effective governance and opera-

tions of the regulator and the regulated depend on the broader legal frame-

work governing the insolvency regime and creditor rights, ownership,

contracts, contract enforcement, accounting and auditing, disclosure and

other aspects of corporate governance.

The legal framework is based on legal tradition and history more than any

other aspect of the financial system. There are five main legal traditions, which

originated in Europe with the advent of modern laws and have been adopted

throughout the world on the basis of colonial history, commercial association and

geography. There is wide variation of legal traditions within the G20 (table 1).

Considerable analytical and empirical work has been undertaken on the

influence of legal tradition. The law and finance theory emphasizes two inter-

related channels through which legal tradition influences financial develop-

ment. The political channel holds that civil law systems tend to promote the

development of institutions that advance state power with negative implica-

tions for financial development. The adaptability channel stresses that some


328

legal traditions differ in terms of their responsiveness to changing socioeco-

nomic conditions. Since inflexible legal traditions produce gaps between legal

capabilities and commercial needs, historically determined differences in legal

tradition can shape the structure and attributes of financial systems. The

adaptability channel suggests that countries with a French legal origin are

more likely to develop rigid legal systems than countries whose systems are

based on British common law or German civil law because of the complexity

of judicial processes, with repercussions for financial development thanks to

higher costs and longer duration for judicial actions.

Another important channel through which legal tradition affects the legal

framework is creditor rights. The protection of creditors determines how much

and on what basis they participate in financial markets. Countries have taken

different paths to expand credit and ensure its effective allocation. Two types

of institutions expand access to credit and improve its allocation: credit infor-

mation registries or bureaus, and creditor rights in the country’s secured-trans-

actions, collateral and bankruptcy and insolvency laws. They operate best

together—information sharing allows creditors to distinguish good from bad

clients, while legal rights to enforce claims minimize perverse incentives and

help in the event of default. Countries in the common law tradition rely more

on creditor protections in the law. Empirical findings from the law and finance

studies suggest that common law countries have the strongest protection of

outside investors—both shareholders and creditors—whereas French civil law

countries have the weakest.2 Lenders also face more delays and higher costs of

enforcing collateral in French civil law countries. To compensate for weaker col-

lateral and bankruptcy and insolvency laws and their enforcement, French civil


329

Table 1

Legal traditions in the G20

English German French Transition Scandinaviancommon civil civil civil civil

Australia Germany Argentina China (none)Canada Japan Brazil Russia

India Republic of Korea FranceSaudi Arabia IndonesiaSouth Africa Italy

United Kingdom MexicoUnited States Turkey

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).

Insolvency regimes and creditor rightsThe costs of providing credit depend on the certitude of creditor rights and

on the costs and delays in recovery of claims. Experience with the financial

crises of the late 1990s showed that the lack of effective insolvency systems can

contribute to financial instability and increase the costs of resolving systemic

crises. A well functioning insolvency system and effective creditor rights are

also key to promoting long-term financial sector development by enabling

financial markets to efficiently price, manage and resolve default risks.

A modern and robust financial system requires transparent and pre-

dictable mechanisms for enforcement of all credit claims based on a sound

insolvency system but equally on well functioning and low-cost mechanisms

outside insolvency. A creditor’s ability to seek prompt payment without going

through an insolvency proceeding is a more efficient means to enforce debt

claims. Accordingly, the legal framework for creditor rights should include

mechanisms that provide efficient, transparent and reliable methods for recov-

ering debt, including control and sale of immovable and movable assets and


330


331

Tabl

e 2

Eff

icie

ncy

of

the

lega

l sys

tem

—cr

edit

or r

igh

ts,e

ase

ofco

ntr

act e

nfo

rcem

ent a

nd

bu

sin

ess

clos

ure

Cred

itor r

ight

sEn

forc

ing

cont

ract

sCl

osin

g a

busi

ness

Lega

l rig

hts

Num

ber o

fTi

me

Cost

Tim

eCo

stRe

cove

ry ra

teCo

untry

inde

xpr

oced

ures

(day

s)(%

of d

ebt)

(yea

rs)

(% o

f est

ate)

(cen

ts o

n th

e do

llar)

Arge

ntin

a3

3352

015

2.8

1823

.5Au

stra

lia9

1115

714

.41

880

.0Br

azil

225

566

15.5

108

0.2

Cana

da7

1734

612

0.8

489

.1Ch

ina

225

241

25.5

2.4

1835

.2Fr

ance

321

7511

.71.

98

46.6

Germ

any

826

184

10.5

1.2

850

.3In

dia

440

425

43.1

108

12.5

Indo

nesi

a5

3457

012

6.5

618

10.6

Italy

318

1,39

017

.61.

218

43.5

Japa

n6

1660

8.6

0.5

492

.4M

exic

o2

3742

120

1.8

1864

.5Sa

udi A

rabi

a—

4436

020

2.8

1831

.7So

uth

Afric

a6

2627

711

.52

1831

.8Tu

rkey

122

330

12.5

2.9

825

.7Un

ited

King

dom

1014

288

15.7

16

85.8

Unite

d St

ates

7

1725

07.

53

868

.2

G20

aver

age

525

380

22.8

312

46.6

Sam

ple

aver

age

530

381

30.1

3.3

1632

.6

Best

pra

ctic

e11

274.

20.

41

92.4

Aust

ralia

Tuni

sia

Nor

way

Irela

ndCo

lom

bia,

Fin

land

,Ja

pan

Kuw

ait,

Net

herla

nds,

N

orw

ay, S

inga

pore

— N

ot a

vaila

ble.

Sour

ce:W

orld

Ban

k, D

oing

Bus

ines

s Da

taba

se, 2

005


332

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.

• Prevent the premature dismemberment of a debtor’s assets by indi-

vidual creditors seeking quick judgments.

• Provide a transparent procedure that contains, and consistently

applies, clear risk allocation rules and incentives for gathering and

dispensing information.

• Recognize existing creditor rights and respect the priority of claims

with a predictable and established process.

• Establish a framework for cross-border insolvencies, with recogni-

tion of foreign proceedings.

The World Bank has developed a set of Principles and Guidelines for

Effective Insolvency and Creditor Rights Systems in collaboration with a range

of international partner organizations and numerous international experts

and benefiting from feedback from more than 700 public and private spe-

cialists from some 75 countries. Since April 2001 the principles have served as

the basis for pilot assessments as part of the Reports on the Observance of

Standards and Codes (ROSC) initiative,4 and they provide a framework for

comprehensively assessing the effectiveness of insolvency and creditor rights

systems against international best practices. A set of core principles are elab-

orated under 35 topics in four primary areas: creditor rights and enforcement

systems (for secured and unsecured credit); corporate insolvency systems (liq-

uidation and rescue legislative procedures); credit risk management, debt

recovery and informal enterprise workout practices; and effective implemen-

tation of legal mechanisms (institutional and regulatory frameworks).

The following key issues and lessons have emerged from the program to

date:

• In several countries deficiencies have been identified in legislation

governing creation and registration of security interests, especially

over movable assets; commercial enforcement proceedings for both

unsecured and secured claims; and insolvency proceedings, particu-

larly reorganization.

• The most significant deficiencies identified for the countries assessed

under the program relate to weak institutional and regulatory frame-

works—that is, weakness in the implementation mechanisms for

enforcement and insolvency procedures. In most assessed countries

lack of favorable conditions for out-of-court reorganization mecha-

nisms (workouts) has been detected.

• The most common institutional problems stem from inadequate

training of judges and administrators; inefficient case administration


333


334

practices and procedures; lack of transparency and consistency in

decisionmaking; and ineffective regulation to redress problems of

corruption and undue influence on the courts, administrators and

trustees and other stakeholders.

ACCOUNTING AND AUDITING SYSTEMS AND PRACTICES

Sound accounting and auditing systems and practices are a pillar of the infor-

mation infrastructure for financial sector development, robust market discipline

and effective official supervision. Other pillars are the framework for monetary

and financial policy transparency (legal and institutional arrangements that are

embodied in the IMF Code of Good Practices on Transparency in Monetary and

Financial Policies and that affect the quality, availability and transparency of

information on monetary and financial policies and conditions at all levels) and

credit reporting and financial information services that enable financial markets

to generate and share information on financial conditions and credit history of

borrowers and other issuers of financial claims. Accounting and auditing stan-

dards of high quality provide the basis for reliable and transparent disclosure of

information to relevant stakeholders. By defining and validating the information

that is disclosed to the public and the regulatory authorities, the accounting and

auditing framework is crucial for informed financial decisions, efficient resource

allocation and the effective functioning of markets.

Under more revision and modernization, accounting and auditing stan-

dards have been developed by the International Accounting Standards Board

and the International Federation of Accountants.5 The International Financial

Reporting Standards (IFRs) issued by the International Accounting Standards

Board encompass both the previously adopted—and in some cases

amended—International Accounting Standards (IAS), as well as newly devel-

oped IFRs. There are currently 41 IFRs, some of which are particularly impor-

tant for financial sector disclosure. This includes IAS 32 and IAS 39, which

provide guidance on the recognition, measurement and disclosure of finan-

cial instruments, and IAS 30, which applies to the disclosure by banks and

similar institutions of their income statement and balance sheet as well as off-

balance sheet contingencies. While these standards are aimed at improving

the disclosure of financial risks, major challenges remain in international con-

vergence and in aligning prudential standards with evolving accounting stan-

dards. The International Standards on Auditing are issued by the International

Auditing and Assurance Board, which functions as an independent standard

setter under the auspices of the International Federation of Accountants.

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

• There is an urgent need for the International Accounting Standards

Board to specify the circumstances in which the use of “full” IAS/IFRs

is appropriate, to develop different standards that would meet the

needs applicable to the users of financial statements of other entities,

particularly small and medium-size enterprises.

• Effective accounting and auditing regulation is required to underpin

effective incentives, but international accounting and auditing stan-

dards themselves do not set requirements as to how such effective reg-

ulation should be exercised. Guidance is not provided on how to

“import” international standards into national legislative and regula-

tory systems, on the design and operation of appropriate regulatory

frameworks, or on the interfaces with other regulatory bodies and

instruments (such as those for banking and securities regulation) which

could contribute to the monitoring and enforcement of international

standards. Reaching an international consensus on a common frame-

work of principles for the regulation and supervision of the account-

ing and auditing profession therefore remains an important task.

• Mechanisms for public oversight of the audit function, including the

setting of audit standards and the assurance of audit quality, are almost

entirely absent in most developing countries. Models introduced

recently in more developed jurisdictions may not always be applica-

ble in situations where the relative importance of the various stake-

holder groups is different, and national regulators do not always have

easy access to emerging international best practice and consensus.

• In many developing and emerging market countries observance of

accounting and auditing standards is constrained by the lack of access

to the standards and related publications by students and profes-

sionals, nonavailability of standardized implementation guidelines

and practice manuals in a country context, failure to provide proper

training on the practical application of both standards and the code

of ethics for professional accountants and auditors and lack of an

academic environment with sufficient curriculum, appropriate aca-

demic literature and enough well trained instructors. Mobilizing the

necessary human resources and strengthening the institutional

underpinnings is a long-term challenge.

• Increased participation of developing countries in developing and

revising the standards is critical to facilitate design and implementa-

tion of standards that reflect the realities in developing countries.


336

CORPORATE 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

The principles have been developed keeping in mind primarily nonfi-

nancial firms, but the core principles apply equally well to financial firms.

However, governance of financial institutions (particularly banks) requires

additional controls and safeguards above and beyond the normal corporate

governance practices and standards that apply to nonfinancial firms.6 Several

key issues arise in assessing and strengthening financial sector governance.

What is the impact of regulatory governance on the overall effectiveness and

supervision and soundness of the financial system? How should regulatory

governance and regulatory policies in individual sectors be adjusted to rein-

force governance of financial institutions? How should policymakers encour-

age regulated financial institutions to focus more on the quality of governance

of their counterparties (financial and nonfinancial firms, households, gov-

ernment)?

As part of the ROSC initiative, the Bank developed a template to assess a

country’s corporate governance framework and company practices against

the OECD Principles for Corporate Governance. Each OECD principle is eval-

uated with respect to underlying policies and actual practice. The template

gathers both quantitative and qualitative information on ownership and con-

trol structure of listed companies, capital market structure, legal and institu-

tional factors affecting corporate governance, rights and obligations of listed

companies, intermediaries and investors in a given country, relevant disclo-

sure practices and the functions and responsibilities of governing bodies of the

corporation. To date the Bank has completed ROSC assessments for more

than 40 emerging market and developing countries.

Based on the experience gained in implementing the ROSC initiative so

far, and the Bank’s engagement in the global debate on corporate governance,

the following key lessons have emerged:

• None of the countries assessed under the ROSC initiative comply

with the OECD principles in all aspects. However, all countries sur-

veyed have undertaken or are undertaking reforms to align their legal

and regulatory frameworks with the principles.

• Experience from the surveyed countries demonstrates the lack of an

efficient legal and regulatory framework and of the means for secu-

rities regulators to enforce the rules and regulations of their capital

markets. Courts are typically underfinanced, unmotivated, unclear as

to how the law applies, unfamiliar with economic issues or even cor-

rupt. Moreover, securities regulators have little direct power to

enforce penalties. Enforcement of prevailing rules and regulations is


338

mostly the responsibility of the courts, leading to poor enforcement

of the rules and regulations underlying corporate governance. In

countries with weak regulatory environments concentrated enforce-

ment through the market regulators may be preferable to enforce-

ment through the courts.

• The enforcement of shareholder rights and equitable treatment of

shareholders needs strengthening. In most countries business trans-

actions have traditionally taken place on the basis of relationships

and trust, and little attention has been paid to publicly available infor-

mation.

• To enhance the relevance of OECD principles for developing coun-

tries and transition economies, it is important to consider various

forms of organizing companies when incorporating, and policy-

makers should offer issuers different corporate governance options—

in terms of disclosure and governance standards—as a means to

pragmatically promote reforms. At the same time, some standard-

ization of options is desirable to lower transactions costs for issuers

and investors alike.

WORLD BANK SUPPORT FOR INSTITUTION BUILDING IN THE

FINANCIAL SECTOR

The World Bank Group’s support for the financial sector is an integral part of

its mission to enhance growth and reduce poverty. Over fiscal 2000–04 the

World Bank Group has provided $16.2 billion of lending and investment sup-

port to the financial sector—$10.3 billion of it from International Bank for

Reconstruction and Development–International Development Association

resources and $5.9 billion through International Finance Corporation (IFC)

loans and equity investments. Most of this support is aimed at financial sec-

tor reform and long-term financial sector development, including institution

building. Equally important are the technical assistance and capacity building

activities delivered by Bank staff and consultants and through third-party

technical assistance financed by Bank loans. Overall, the World Bank Group

provides about $100 million a year in funding for technical assistance and

capacity building activities in the financial sector. The Bank’s engagement in

the financial sector is underpinned by an extensive policy and research pro-

gram, including the provision of databases and analytical tools.7

The World Bank’s lending for technical assistance helps capacity building

in a wide range of areas. About half deals with banking sector restructuring,


339

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

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


341

success factor in this regard is the establishment of a multidisciplinary steer-

ing committee, including representatives of the government, regulators, aca-

demicians and the private sector, at the outset of the assessment to drive the

implementation of the reform agenda. Many of these activities were carried

out in close cooperation with regional development banks, bilateral donors

and others, often with financial support from other development partners. In

association with the ROSC initiative the Bank has also organized a growing

number of outreach and training activities. One important such activity was

a two-day roundtable on the accounting and auditing ROSC in February 2005,

which brought together management and staff from the Bank, international

standards-setting bodies (International Accounting Standards Board,

International Federation of Accountants), international organizations of

financial regulators (Basel Committee on Banking Supervision, IAIS, IOSCO),

the Financial Stability Forum, regional development banks and members of

government from eight client countries.

As a follow-up to corporate governance assessments, the Bank has pro-

vided a range of support to countries ranging from a technical assistance loan

aimed at enhancing the transparency of the financial system and the effec-

tiveness of regulation and supervision for both the banking system and secu-

rities markets, to establishment or strengthening of institute of directors in

several countries. An important vehicle to strengthen corporate governance is

IFC’s Private Enterprise Partnership, a business advisory program that offers

training and information to companies and works with policymakers to

improve implementation of corporate governance regulation.

The World Bank Group has been collaborating with the OECD on three

initiatives to strengthen corporate governance in developing countries: the

Global Corporate Governance Forum, the regional Corporate Governance

Roundtables and a senior-level Private Sector Advisory Group. The Global

Corporate Governance Forum supports corporate governance reform by

funding technical assistance and capacity building, leveraging private sector

input, promoting research relevant to the needs of emerging markets and dis-

seminating best practices. Regional corporate governance roundtables in Asia,

Latin America, Russia and Southeastern Europe have helped promote better

understanding and engagement of policymakers, regulators and standards-set-

ting bodies, including stock exchanges in the corporate governance agenda.

The senior-level Private Sector Advisory Group, established in 1999, engages

private sector counterparts in developing countries that are key players in

improving the corporate governance environment.


342

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.

NOTES

1. See World Bank (2001a) for a review of research findings on finance andgrowth.

2. See, for example, La Porta and others (2000).

3. The methodology used to define the benchmarks and the indicators usedare described in detail in World Bank (2005).

4. The principles are under revision based on further feedback, consultationsand lessons learned from the pilot ROSCs. The Bank is currently collaboratingwith the IMF and the United Nations Commission on International Trade Lawto develop a unified standard on insolvency and creditor rights systems.

5. Trends in globalization, capital flows, regionalization and technology areinfluencing the standards-setting process. Recent events in industrial countriesrelating to corporate business failings and inaccuracies in financial reporting havealso brought attention to the role and oversight of the accounting and auditingprofession, the governance of standards-setting bodies, and the scope of corporate


343

governance as it relates to reporting and disclosure.

6. For example, the Basel Committee on Banking Supervision has issued arange of guidance documents including Enhancing Corporate Governance forBanking Organizations (1999).

7. The Bank endeavors to disseminate not only its own research, but researchfrom the world relevant to financial sector development in member countries. Forinformation about the Bank’s research program, seehttp://econ.worldbank.org/programs/finance/.

REFERENCES

Basel Committee on Banking Supervision, 1999. Enhancing Corporate Governancefor Banking Organizations. Bank for International Settlements, Basel.

Beck, T., A. Demirgüç-Kunt, and R. Levine. 2003. “Law, Endowments, andFinance.” Journal of Financial Economics 70(2): 137–81.

Diamond, J. 1997. Guns, Germs, and Steel: The Fates of Human Societies. NewYork: W.W. Norton.

Easterly, W., and R. Levine. 2003. “Tropics, Germs, and Crops.” Journal ofMonetary Economics 50(1): 3–39.

La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny. 1997. “LegalDeterminants 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 ofFinancial 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 Primacyof 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. PolicyResearch Report. Washington, D.C.

———. 2001b. Principles and Guidelines for Effective Insolvency and Creditor RightsSystems. 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 DEVELOPING

STRONG DOMESTIC

FINANCIAL MARKETS

OTTAWA, CANADA

26–27 APRIL 2004

SUMMARY OF PROCEEDINGS

FROM THE G20 WORKSHOP

ON DEVELOPING STRONG

DOMESTIC FINANCIAL MARKETS

PREPARED BY THE BANK OF CANADA AND THE DEUTSCHE BUNDESBANK

OTTAWA, CANADA, 26–27 APRIL 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.

GENERAL 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

347

markets while maintaining prudential supervision and regulation. Next, open

the current account. And finally, eliminate restrictions on capital movements,

starting with the liberalization of long-term flows. Questions were raised,

however, about the speed of liberalization. Participants broadly endorsed the

concept of exchange rate flexibility for countries with widely opened capital

accounts, agreeing that a high degree of exchange rate flexibility provides an

incentive to monitor and control currency mismatches.

It was also recognized that many emerging market economies have, over

the past decade, made substantial progress in strengthening their domestic

financial markets. Local bond markets are now the dominant source of fund-

ing for governments. There has been a surge in domestic corporate bond issues

as well, though progress has been slower in this segment of the market. A dri-

ving force behind the development of local securities markets has been the

rapid growth of nonbank institutional investors, particularly pension funds in

Latin America and insurance companies in Asia, which have a strong appetite

for long-term investments, given the long term of their liabilities.

Despite the significant progress in improving domestic financial markets

in recent years, G20 members recognized that currency mismatches will

remain an important source of vulnerability for the foreseeable future and

that further policy efforts are necessary to contain risks. Cooperation in the

development of regional financial markets could also be fruitful, especially

for smaller markets.

Participants agreed that further work is necessary to strengthen domes-

tic financial markets. There was also broad agreement that the continued shar-

ing of experiences among the G20 countries is an important avenue for

advancing this work. Areas deemed critical for fostering strong domestic finan-

cial markets included:

• Sustained sound macroeconomic policies are an essential precondi-

tion for the development of domestic banking systems and bond

markets, especially for the ability of domestic borrowers to issue long-

term debt denominated in domestic currency. Appropriate incentives

were also viewed as key, with most participants endorsing a substan-

tial degree of exchange rate flexibility for countries with liberalized

capital movements as a means of encouraging better management of

currency mismatches.

• Further work is required to strengthen the financial infrastructure,

focusing on implementing and enforcing internationally recognized

codes and standards, including those related to corporate governance

WORKSHOP ON DEVELOPING STRONG DOMESTIC FINANCIAL MARKETS

348

and transparency. Robust payment and settlement systems should also

be established. Accounting rules should not discriminate against bor-

rowing in domestic currency relative to foreign currency. Strong con-

tract law and property rights are also essential for market development.

• Work must continue on strengthening banking systems, which com-

plement strong securities markets. Many participants agreed that the

entry of foreign banks could increase local funding of domestic busi-

ness and reduce currency mismatches.

• Other practical steps to reduce currency mismatches and strengthen

domestic bond markets include reducing the proportion of foreign

currency–denominated or exchange rate–linked debt in government

debt and establishing a domestic benchmark yield curve.

• Prudential oversight must take currency mismatches into account

from both micro and macro perspectives.

Keynote address: Barry Eichengreen, University of California, BerkeleyIn the keynote address to workshop participants, Barry Eichengreen noted

that there are two views on the extent to which local financial markets have

developed in emerging market economies in Asia. An optimist would high-

light the growth of local markets, the growing diversity of issuers since the

1997–98 Asian crisis and the expectation that rapid growth would continue

in light of strong demand for investment instruments, given high domestic

savings ratios. A pessimist, however, would stress the limited number of high-

grade borrowers and the lack of liquidity, as well as the fragmented local mar-

kets and regulatory obstacles. He suggested that the truth probably lies

somewhere between these two extremes.

Eichengreen also noted that Asian governments have done much to build

the necessary infrastructure to develop their bond markets.At the national level,

among other initiatives, calendars for government bond issues have been estab-

lished. The supply-demand mismatch has been addressed by encouraging issues

of corporate bonds.At the regional level, cooperation among various groups has

led to the Asian Bond Fund, helping address the problem of small markets.

He argued strongly, from a number of perspectives, in favor of greater

exchange rate flexibility in Asia. He noted that the 1997–98 Asian crisis

demonstrated that growing capital account convertibility, while necessary for

deep local and regional markets, is risky in the absence of exchange rate flex-

ibility. Exchange rate flexibility would encourage the development of finan-

cial instruments for hedging purposes. And by severing the link with the U.S.

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349

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.

CHALLENGES IN THE ABSENCE OF STRONG D OMESTIC FINANCIAL

MARKETS

Presenter: Philip Turner, Bank for International SettlementsPhilip Turner focused his remarks on currency mismatches, an important fac-

tor in triggering or aggravating financial crises in emerging market econo-

mies.1 Currency mismatches arise when borrowers incur foreign currency

liabilities to finance domestic activities. In the aftermath of large exchange

rate depreciations, economies with currency mismatches can experience seri-

ous adverse effects. Financial intermediaries can come under pressure, because

of mismatches in their own balance sheets or to corporate insolvency. This, in

turn, can lead to a decline in economic activity.

Turner took issue with the concept of “original sin”, a hypothesis that

traces currency mismatches to a fundamental inability of emerging markets

to borrow abroad in their own currency (Eichengreen and Hausmann 1999;

Eichengreen, Hausmann and Panizza 2003). While agreeing that very few

emerging market economies can issue debt abroad in their own currency, he

argued that it was important to take a broader view of currency mismatching

and its implications. It is important to look at the currency of denomination

of all debts, including local bank lending and debt contracts, and to evaluate

the impact of a change in the exchange rate on the discounted present value

of all future income and expenditure flows.

Turner developed a measure of the aggregate effective currency mismatch

as a stress test for an economy facing a large currency depreciation. The mea-

sure consists of three elements: net foreign currency assets, exports of goods

and services and the foreign currency share of total debt. He noted that China

and India had avoided aggregate mismatches, while other Asian economies

that had been vulnerable in 1997 had now virtually eliminated their aggregate

mismatch. But Argentina, Brazil and Turkey continued to have mismatches in

2002 and thus remained vulnerable to large depreciations of their currencies.

He also noted that Brazil had made substantial progress in limiting govern-

ment issuances of dollar-linked paper.

Finally, Turner outlined an agenda for a six-step domestic policy that

would reduce the vulnerability of emerging market economies with open cap-

ital markets to exchange rate depreciation.


350

• A high degree of exchange rate flexibility (combined with a monetary

policy that targets inflation) to remind players of exchange rate risk.

• Greater transparency and better data to facilitate the monitoring of

currency mismatches.

• Government borrowing only in local currency to reduce currency

mismatches in the economy as a whole and to improve macro-

economic discipline.

• Foreign bank entry to increase the share of local currency lending

and to encourage better banking skills.

• Elimination of impediments to bond market development.

• Increased “mismatch awareness” as part of prudential oversight.

Discussants: Representatives of the Central Bank of Brazil and the CentralBank of TurkeyThe representative of the Central Bank of Brazil agreed with Turner’s thesis,

endorsed his policy recommendations and argued that a country’s future lies

in the hands of policymakers. Good domestic economic policy will permit

emerging market economies to reduce their vulnerability to currency mis-

matches. He contended that the development of Brazil’s local currency bond

markets was undermined by several factors, including uncertainty over prop-

erty and savers’ rights as well as macro policy. He noted that Brazil has taken

steps to reduce its vulnerability by allowing its exchange rate to float and by

decreasing the amount of dollar-linked bonds issued by the government.

Foreign banks are also welcome in Brazil.

The delegate of the Central Bank of Turkey echoed many of these com-

ments, noting that the real origin of Turkey’s vulnerability has been govern-

ment deficits. Like Brazil, Turkey adopted a flexible exchange rate, which

improved risk management. He also noted that while maturities on Turkish

debt instruments were short, they have been lengthening. He updated Turner’s

mismatch analysis for Turkey, noting that Turkey had eliminated its currency

mismatch in 2003, due to a decline in foreign currency government debt. A

decrease in domestic real interest rates in recent years, caused by a fall in

domestic inflation, has encouraged a shift away from foreign currency bor-

rowing to local currency borrowing.

General discussionParticipants debated whether currency mismatches can be significantly reduced

by appropriate economic policies and institution building in emerging market

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351

economies—or whether they are beyond the control of policymakers. There

was a broad consensus that the original sin explanation for currency mis-

matches was too narrow—or even unfounded. While small industrialized

countries, with few exceptions, are unable to issue international bonds in their

own currency, they have been able to develop strong banking systems and deep

local bond markets that attract significant foreign interest. It was further noted

that countries with large trade surpluses or high reserve holdings are perceived

as more capable of sustaining currency mismatches than those with weak pay-

ments and reserves positions.

Most participants appeared to endorse the policy recommendations in

Turner’s presentation, although it was evident that the call for a high degree

of exchange rate flexibility is most relevant for countries that have already

widely liberalized their capital account.

FINANCIAL INTERMEDIATION AND ECONOMIC GROWTH

Presenters: Gerard Caprio, World Bank, and Martin Hellwig,Max Planck Institute for Research on Collective GoodsGerard Caprio surveyed the evidence on the contribution of financial sector

development to economic growth, indicating that sound financial institutions

and markets can contribute to growth, mainly by improving productivity

through a more efficient allocation of savings. Having said this, neither the

financial structure by itself (the reliance on financial intermediaries versus

capital markets) nor the nationality of financial services providers matters for

growth. So, it is better to build a solid financial infrastructure than to aim for

a particular model.

The key is to recognize that well functioning markets need accurate and

timely information and strong legal and regulatory underpinnings. To get the

basics right, the authorities have to be aware of the incentives that an institu-

tional structure can create, for good or bad. In practical terms, this means that

supervisors of the financial system must be both publicly accountable and

independent of the institutions they regulate. While technical expertise and

technology to reduce informational and transactions costs in the financial

sector can be bought, the legal framework must be developed within the coun-

try. Experience shows that legal frameworks that protect outside creditors and

investors favor financial development and investment.

In a complementary presentation Martin Hellwig focused on long-term

sustainable growth. He made three major points. First, the chief impetus today

for long-term growth is innovation, financed in large part by risk capital


352

(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.

Discussants: Representatives of the Reserve Bank of Australia, the Board ofGovernors of the Federal Reserve System and the Japanese Ministry of FinanceThe representative of the Reserve Bank of Australia concurred with both pre-

sentations. He noted that Australia had benefited from financial reforms by

promoting competition and by accepting flexibility in financial prices. He

encouraged emerging market countries to move faster on reforms, acknowl-

edging that training and retaining qualified personnel for prudential super-

vision is a challenge.

The delegate representing the Board of Governors of the Federal Reserve

System also agreed with the presenters’ comments. He added that countries

with both banking and capital market systems were more resilient to shocks.

He also stressed the importance of the legal system and the continuing need

to adapt it to financial innovation.

The representative of the Japanese Ministry of Finance spoke of the dif-

ficulty of moving the Japanese banking culture from a relationship basis to an

arm’s length basis. Despite substantial reforms, including financial deregula-

tion and improved disclosure and accounting rules, the actual shift in market

structure has been slow. Japan’s experience has been that building a new finan-

cial system is resource-intensive and that the benefits are slow to emerge.

Perseverance is required; otherwise, significant reforms might be considered

only in a crisis.

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General discussionSeveral 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.

THE SEQUENCE OF FINANCIAL LIBERALIZATION AND

SUPERVISORY REFORMS

Presenter: Ronald McKinnon, Stanford UniversityRonald McKinnon placed financial crises in a historical perspective. Before the

Great Depression, economic and financial policies were dictated by the exi-

gencies of the gold standard. Large capital flows prevailed, and financial crises

were common. For the most part, however, these crises were resolved fairly

quickly, through a combination of fiscal consolidation, a reaffirmation of

sound monetary policy and lending by international banking houses acting

as crisis managers.

The Great Depression discredited the gold standard, which led to the Bretton

Woods system of pegged, but adjustable, exchange rates following World War II.

Most countries resorted to restrictions on capital accounts and domestic finan-

cial repression to maintain the pegged rates and finance domestic development.

These policies had undesirable effects. Capital controls led to the growth

of unregulated markets as banks sought to evade them, while the widespread

adoption of explicit or implicit deposit insurance encouraged banks to reduce

their capital-asset ratios. And as capital controls and domestic regulations

were progressively eased or evaded through the 1980s, these factors led to

overborrowing. Financial repression was replaced by financial crashes.

These weaknesses underscored the importance of following the appro-

priate order of financial liberalization. According to McKinnon (1993), the

starting point is fiscal balance, followed by domestic financial liberalization

and the development of prudential bank regulations. Current account liber-

alization should proceed in tandem with domestic financial liberalization.

Capital account liberalization should be the final element of the sequence,

with long-term capital flows, especially foreign direct investment, liberalized

before short-term flows.


354

To minimize the risk of financial crises, McKinnon favored a new mone-

tary order to stabilize exchange rates, using the U.S. dollar as the key currency.

He recommended that debtor emerging market economies encourage illiquid

forms of capital inflows, such as direct foreign investment, develop their

domestic financial markets, lengthen the maturity of obligations linked to the

exchange rate, limit the net foreign exchange positions of banks and use cap-

ital controls if bank regulations are weak. Creditor emerging market econo-

mies—which, he argued, suffer from “conflicted virtue”—should do much

the same thing.2 But they should encourage less liquid capital outflows. He also

recommended that these economies “nationalize” capital outflows through

national savings programs (citing Singapore’s Provident Investment Fund) or

reserve accumulation. To make the system function, obligations would also be

imposed on the United States, whose currency would anchor the system. The

United States would be required to maintain open capital markets, focus pol-

icy on stabilizing the U.S. price level rather than the exchange rate (and refrain

from pressuring others to change their rates) and reduce its trade deficit

through higher domestic savings.

Discussants: Representatives of the People’s Bank of China and Banque de FranceThe representative of the People’s Bank of China noted that, before 1978, his

institution was the only bank in the country. Today, the Chinese financial sys-

tem includes not only several domestic commercial banks, but 178 foreign

bank branches or subsidiaries and 120 other foreign financial institutions.

Capital markets have also grown rapidly, with more than 1,400 companies

now listed on various exchanges. While many capital restrictions remain, he

noted that important steps have been taken to liberalize the system, including

the introduction of a single, unified exchange rate in 1994. Moreover, of 43

capital account transactions monitored by the International Monetary Fund

(IMF), 8 have been liberalized, while 11 other restrictions have been eased. The

others will be gradually relaxed, depending in part on the strength of the bank-

ing system. In this respect, he stressed the importance the Chinese authorities

attach to financial stability and the sequencing of reforms.

The representative of Banque de France also acknowledged the degree to

which the liberalization of the French financial sector followed the McKinnon

“order”. The starting point, he said, was the creation of deep, liquid markets

for public debt instruments. Consistent with the McKinnon paradigm, how-

ever, a commitment to long-run fiscal discipline was necessary to reduce the

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risk premium on long-term bonds. At the same time, wide-ranging reform of

the legal environment, as well as strengthening the prudential regulatory and

supervisory framework, contributed to the development of domestic capital

markets. These, in turn, necessitated a new market-led framework for mone-

tary policy.

The delegate of Banque de France also noted that restrictions on current

account transactions were liberalized before the 1980s, when gradual capital

account liberalization began as part of the elimination of controls entailed in

the integration of European economic and monetary systems. Drawing on

the French experience, he concluded that trade liberalization should go hand

in hand with domestic financial liberalization. Moreover, financial liberaliza-

tion should be carried out cautiously and gradually, with the sequencing of

reforms tailored to the economy.

General discussionThere 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


356

that, in the current Asian context, characterized by a de facto currency zone, it

might be disruptive if only one country moved to a floating rate.

INFRASTRUCTURE BUILDING AND GOVERNANCE

Presenters: Amar Bhattacharya, World Bank, and Sabine Miltner, Instituteof International FinanceAmar Bhattacharya focused his remarks on policies and institutions. He under-

scored the importance of supervisory principles relating to banks, securities

markets, insurance and the payment systems that have been established by the

international standards-setting bodies. He also noted the importance of prin-

ciples dealing with corporate governance, audit and accounting standards,

insolvency and creditor rights, as well as money laundering and the financing

of terrorism. While G20 countries have largely adopted internationally accepted

standards, Bhattacharya thought that attention now needs to be directed toward

enforcement. More broadly, he believed that reforms are just beginning to pen-

etrate business culture in many emerging market economies.

He also contended that financial markets in many emerging market

economies suffer from a lack of transparency. Progress is required at all lev-

els: nonfinancial corporations, financial institutions and supervisory and reg-

ulatory authorities. Opaque markets are also reinforced by entry barriers, a

lack of contestable markets and government ownership. Opaque ownership

structures and non–arm’s length transactions also contribute to deficient pri-

vate sector monitoring.

Bhattacharya concluded with an examination of the legal issues pertain-

ing to emerging markets. He noted that G20 countries have different legal sys-

tems (such as common law versus civil code) that gave rise to different

practices. While some traditions provide stronger legal protections than oth-

ers, markets have often developed compensatory devices.

In a complementary presentation Sabine Miltner examined corporate

governance in emerging market economies from the viewpoint of the investor

community. Most broadly, she noted that countries that protect their share-

holders tend to have larger capital markets because investors are willing to

pay a premium for companies with good corporate governance. Drawing on

principles established by an Institute of International Finance working group

on corporate governance and transparency, Miltner stressed five key elements

of good governance: minority shareholder protection, the structure and

responsibility of boards of directors, accounting and auditing, transparency

of ownership and control and the regulatory environment. She also noted that

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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.

Discussants: Representatives of the Reserve Bank of India and the Bank of RussiaThe delegate of the Reserve Bank of India provided a comprehensive overview

of India’s regulatory framework, underscoring the importance of a sound

framework for market development. She noted the sequence of planned mar-

ket reforms since the early 1990s. These have included the liberalization of

foreign exchange markets, the deregulation of interest rates, the development

of a government securities market and the introduction of an over-the-

counter market in derivatives. Interest rate futures were introduced in 2003.

A gross real-time settlement system was also recently introduced to provide

real-time payment finality.

So, over the past decade Indian financial markets have been transformed,

moving from fixed exchange rates and administered interest rates to market-

determined rates with efficient price discovery and a well developed payment

and settlement system. Some remaining issues, such as permitting the short-

selling of government securities, will be addressed at the appropriate time.

Discussions are under way on eliminating the legal ambiguities associated

with over-the-counter derivatives and netting legislation. Work is also under

way to move to screen-based trading of government securities.

In an overview of the Russian payment system the Bank of Russia’s rep-

resentative noted that there are two major players, the Bank of Russia and a

private payment system. Payments processed through the central bank account

for slightly less than 50 percent of payments by volume and 60 percent by

value. While almost all these payments are electronic, they have not been cen-

tralized. Instead, most transactions were processed regionally. The majority of


358

payments are by payment orders—payment by check is almost unheard of.

Since 2001 payment cards have rapidly grown in popularity, virtually all of

them debit cards, used mostly for cash withdrawals. The Russian authorities

envisage moving to a two-tiered payment system, including a “mass payments”

system and a gross real-time settlement system.

General discussionParticipants 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.

BUILDING STRONG LO CAL SECURITIES MARKETS

Presenter: Donald Mathieson, International Monetary FundDonald Mathieson outlined the results of an IMF study, Emerging Local

Securities and Derivatives Markets (Mathieson and others 2004). He reviewed

the experience with capital flow volatility in the 1990s, noting that crises in

emerging market economies resulted both from problems in these economies

and problems in mature markets that spilled over to them. In response, emerg-

ing market economies have adopted numerous complementary strategies to

protect themselves. Among them are better external asset and liability man-

agement, including a buildup of international reserves, continuing use of cap-

ital controls, adapting policies and reinforcing supervision to the degree of

capital account openness and developing local securities markets. Several

emerging market economies had been successful with the last of these since

domestic bonds had become the major source of public funding.

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He observed that several principles had been broadly accepted by the

international community as a means of strengthening local securities and

derivative markets, such as improving market infrastructure, establishing

benchmarks, increasing corporate governance and transparency and creating

an institutional investor base. He underscored the growing importance of pri-

vate pension funds in Latin America (and to less extent in central Europe)

and life insurance companies in Asia.

Many issues were still being debated, however. Mathieson noted that

observers were divided over the merits of issuing indexed bonds. He argued

that there is a difference between bonds linked to the exchange rate and bonds

linked to inflation, favoring the latter. While understanding the reasons for

linking bonds to the exchange rate, he recommended their elimination as

quickly as possible, since the exchange rate can move sharply, leading to dra-

matic increases in debt-servicing costs. Other issues in the “grey zone” included

the extent to which local rating agencies should be encouraged, the role of

government in developing local equity markets, the extent to which foreign

investors should be encouraged, the challenges posed by derivatives markets

and the interaction between the development of national markets and their

regional integration.

Mathieson finished with a plea to the G20 to increase the availability of

data on local securities markets through the development of user-friendly

websites that would supply information on bonds, such as issuance, yields

and currency composition.

Discussants: Representatives of Goldman Sachs and Company,the Deutsche Bundesbank and the Mexican Ministry of FinanceThe discussant representing Goldman Sachs added a few complementary

points. He stressed the need for macroeconomic stability and a low inflation

environment to improve the attractiveness of local securities markets. Funded

social security systems were also important to create demand for domestic

securities. Foreign investors could help in developing more liquid markets,

though he noted a dilemma: local markets may become deeper but at the risk

of greater volatility. On the question of indexed bonds, he thought that infla-

tion indexing was valuable. However, bonds that index debt servicing to gross

domestic product (GDP) have many problems (notably data revisions) and are

of little interest to fixed-income investors.

The representative of the Deutsche Bundesbank talked about the German

Pfandbrief as a possible avenue for developing local bond markets in emerging


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market economies. The Pfandbrief is a special form of “covered” bank bond

that was instrumental in developing long-term bank lending and domestic

securities markets in Germany after World War II. It is used for two specific

purposes: to finance residential or commercial property and to fund local

authorities, thus granting borrowers indirect access to securities markets.

Compared with other private sector bonds, its main attraction is that it offers

strong guarantees to bond investors. First, the bonds are backed by either

property mortgages or access to the tax income of local authorities. Second,

the issuing banks are committed to backing their bonds with their own capi-

tal. There has never been a default of a Pfandbrief. He also noted that the

Pfandbrief represents the biggest homogenous segment of the German bond

market, important holdings by foreign institutional investors, and that simi-

lar instruments closely modeled on the tried and tested German system are

available in many other European countries (including transition economies).

The delegate of the Mexican Ministry of Finance spoke about his coun-

try’s success in developing local securities markets, outlining two key precon-

ditions. First is macroeconomic stability. In Mexico, this involved four mutually

reinforcing components: fiscal discipline, prudent autonomous monetary pol-

icy, a flexible exchange rate and sound debt management. Second is a strong

legal and institutional framework. In Mexico reforms were implemented to

improve accounting standards and transparency in the public sector and in the

banking industry. Complementary measures included efforts to develop an

institutional investor base and a derivatives market (MEXDER) to hedge

risks—and to issue public debt at various maturities to complete the yield

curve and provide benchmarks to improve market liquidity.

General discussionParticipants 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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CONCLUDING OBSERVATIONS

Presenter: Morris Goldstein, Institute for International EconomicsNoting 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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7. Controlling currency mismatches, an element common to every

financial crisis over the past decade. In assessing the extent of a mis-

match, he contended that a broad definition of assets and liabilities

is important.

Goldstein concluded by noting that there was wide support for a broad

agenda of domestic reform, which would emphasize putting into place policy

regimes that are robust to a range of shocks. This policy agenda would include

greater exchange rate flexibility combined with inflation targeting; more pru-

dent debt management practices; and stronger domestic capital markets, to

reduce reliance on foreign currency borrowing and to develop financial instru-

ments that can help hedge and manage financial risks.

NOTES

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.

REFERENCES

Eichengreen, B., and R. Hausmann. 1999. Exchange Rate and Financial Fragility.NBER Working Paper 7418. Cambridge, Mass.: National Bureau forEconomic Research.

Eichengreen, B., R. Hausmann, and U. Panizza. 2003. Currency Mismatches, DebtIntolerance and Original Sin: Why They Are Not the Same and Why It Matters.NBER Working Paper 10036. Cambridge, Mass.: National Bureau forEconomic Research.

IIF (Institute of International Finance). 2002. “Policies for Corporate Governanceand Transparency in Emerging Markets.” Equity Advisory Group, Washing-ton, D.C.

———. 2003. “Policies for Corporate Governance in Emerging Markets: RevisedGuidelines.” Equity Advisory Group, Washington, D.C.

Mathieson, D., J. Roldos, R. Ramaswanny, and A. Ilyina. 2004. Emerging LocalSecurities and Derivatives Markets. Washington, D.C.: International MonetaryFund.

McKinnon, R. 1993. The Order of Economic Liberalization: Financial Control in theTransition to a Market Economy. Baltimore, Md.: Johns Hopkins UniversityPress.

Turner, P., and M. Goldstein. 2004. Controlling Currency Mismatches in EmergingMarkets. Washington, D.C.: Institute for International Economics.

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