Tsinghua University School of Economics and Management

1
Tsinghua UniversitySchool of Economics and
Management

• Lecture 2
• Financial Stability and Bank Regulation
• Andrew Sheng
• Adjunct Professor, Tsinghua
• September 19 2008

2
Outline

• Structure of Financial Markets
• What is Financial Stability?
• What is Financial Regulation?
• Pick Important Problems, Fix Them and Tell
  Everyone
• Concluding Remarks

3
Finance is a derivative of the Real sector

• Financial Sector intermediates between the
  various parts of the Real Economy - corporate,
  government, households and foreign.
• Derivatives are useful because-
• They help make immovable property divisible
• They lower transaction costs
• They permit leverage (higher profits)
• BUT they carry higher risks and are not
  transparent
• Most banking crisis start with bad assumptions-
• 1970s - corporate loans are good
• 1980s - Governments do not fail (Latin America)
• 2000s - Consumer credit is good
• Financial stability relies on real sector
  stability, plus good risk management and
  governance

4
The Network Economy
The value of a network goes up as the square of
the number of users
MARKET
Knowledge Content Branding
MARKET
MARKET
(Metcalfs Law)
Infrastructure e.g. utilities, communication
MARKET
Quality of Information
MARKET
NETWORK HUB Winner Take All Situation
Ability to stay ahead of competition
MARKET
MARKET
Economies of scale Critical Mass
Quality of Governance
MARKET
MARKET
MARKET
MARKET
5
Four Functions of Capital Market

• Resource Allocation
• Allocate resources efficiently to maximize
  welfare
• Price Discovery
• Generate transparent price signals consistent
  with efficient use of resources
• Risk Management
• Encourage good risk management that diversifies
  losses and profits
• Corporate Governance
• Promote sound corporate governance that provides
  proper incentives.
• Financial system is a system to transact and
  protect property rights of all participants over
  the whole demographic cycle!!!

6
Institutions of Capital Market

• Accurate, timely and accessible information
• Properly aligned incentives
• Educated investor
• Efficient intermediaries
• Strong issuer
• Efficient and robust infrastructure
• Strong prudential framework with enforcement
• We must understand nature of financial market in
  order to regulate it.

7
Micro-Elements of Institutional Building
8
Hierarchy of Financial Markets

• Asset-backed
• securities and
• derivatives
• Corporate bond and
• equity markets
• Government bond market
• Treasury bill market and
• foreign exchange markets
• Money market

? Knowledge, Complexity, Risks
9
Multi-Tier Financial System
Bank loans
Risk transfer
Securities markets
Individuals
Companies
Funds
Personal investment accounts
Production creation
Sales
Source Nomura Institute Capital Markets Research
10
McKinsey INVESTORS SPECTRUM

• Buy turn

• Market depth and long term funding
• Facilitate global allocation of capital

• Dynamic

• Mutual funds

• Pension funds - defined contribution

• Buy hold

• Active traders and arbitrators/ proprietary
  trading desks

• Banks

Investors

• Seek high relative returns above benchmark

• Breadth of investment objectives
• Product innovation

• Retail investors

• Depth of investment capacity

• Seek high absolute returns

• Seek safe, predictable, average returns

• Alternative Investors
• Specialized funds
• High net worth individuals
• Investment bank

• Pension funds -defined benefits

• Employ variety of strategies to minimize risks

• Match future liabilities with investment income

• Insurance companies

• Investment objectives

• Examples

• Role

11
Eight Global Trends

• 1. The age of Capital Markets
• 2. The age of Aging
• 3. The age of Customer Value
• 4. The age of Innovation
• 5. The age of Risk and Regulation
• 6. The age of Global Platforms
• 7. The age of Consolidation
• 8. The age of Realignment

Source McKinsey,2007
12
Key Capital Market Trends

• Demographics around 300 million Asians earn
  US5,000 or more annually by 2020, discretionary
  spenders will grow to 1.4 billion. Huge demand
  for asset management and consumer banking needs
• Wealth management - private banking spreading
  from those with US1 million or more to middle
  income professionals
• Mutual Funds - in US already US7.5 trillion
  market, but becoming more leveraged no longer
  just long-only funds line between mutual funds
  and hedge funds blurred
• Market makers - Asian investment banks still
  small by any standard
• Outsourcing - over 100,000 jobs moved to India
  from US, worth US136 bn in wages trends will
  continue

13
The Global Financial Network
High Knowledge Content Good Branding
Key hubs usually efficient urban centres e.g.
New York London
High Quality Infrastructure
Real time Reliable Information
FINANCIAL MARKETS CONVERGE ON KEY HUBS
Pluralistic, Disciplined, Adaptive Good
Feedback Mechanism
Good Public Private Governance
Liquid Low Friction Cost
14
The Bretton Woods Architecture

• International Monetary Fund, total quota
  (capital) of SDR217.3 bn (USD327.3 bn), 184
  members (March 2007 data)
• World Bank (International Bank for Reconstruction
  and Development), capital US37.6 bn, assets
  US212.9 bn (March 2006)
• Other IFIs include ADB, African Development Bank,
  EBRD, Inter-American Development Bank etc
• Bank for International Settlements (BIS), owned
  by member central banks, equity of US18.2 bn and
  US410.5 bn assets (March 2007)
• Total asset size of these institutions (US951
  bn) is trivial (0.5) compared with size of
  global financial assets of US190.4 trn and 2006
  gross capital outflows for emerging markets of
  US1,941 bn (IMF GFSR Table 1).

15
Post 1998 Architecture

• Financial Stability Forum Central Banks,
  Ministries of Finance, IFIs, Standard Setters,
  Supervisory Agencies
• Major move to incorporate Emerging Market views
• Greater coordination of efforts of different
  implementation agencies, eg IFIs, Standard
  Setters (eg IASC, IOSCO, Basle Committee) and
  supervisory agencies also represented
• BIS acts as secretariat to FSF, currently chaired
  by Mario Draghi (Governor, Bank of Italy)

16
Global Share of Capital Markets, 2006 US
trillion (IMF GFSR Table 3)
17
Global Assets Under Management (US trillion end
2003)

• International Banking Assets (BIS data)
  23.6
• International debt securities 14.6
• Insurance companies 13.5
• Pension Funds 15.0
• Investment Companies 14.0
• Hedge Funds 0.8
• Other Institutional Investors 3.4
• Total 84.9
• (2006 total (include direct holdings
• US190.4 trn)
• Memo OTC Derivative Contracts (notional)
  270.1
• (2006 total US415.2 trn, gross market value of
  U9.7 trn)
• Source BIS, IMF

18
New Players in Global Financial System growing
fast US trillion

2000 2006E CAGR 2000-06E Pension
Funds 16.1 21.6 5 Mutual Funds 11.9 19.3 8 Insu
rance Funds 10.1 18.5 11 Petrodollar
assets 1.2-1.4 3.4-3.8 19 Asian central bank FX
reserves 1.1 3.1 20 Hedge Funds 0.5 1.4 19 Priva
te Equity 0.3 0.7 14 Source MGI, McKinsey
Global Institute Analysis
19
II. Weaknesses in Asian Financial
MarketsStill a bank-dominated system
20
Asia still Dependent on Bank Financing ( of GDP)
Source World Bank Financial Sector Dataset,
February 2006
21
Recent Key Market Trends in Asia

• Deposit-taking Institutions demographics
  changing customer pattern growth of consumer
  banking, credit cards, demand for structured
  products
• Risk-pooling Institutions - still foreign
  dominated, but demand growing
• Contractual Savings Institutions - huge
  liquidity pools, but shortage of professional
  fund management skills
• Market Makers - key investment banking skills
  still dominated by large foreign players, with
  foreign fund managers as key clients
• Specialized Sectoral Financiers - policy-based
  banks shrinking in market size venture capital
  and private equity becoming more important
• Financial Service Providers exchanges
  demutualizing

22
Basic Reforms in Asian Financial Markets

• Corporate Governance improved and de-leveraged
  considerably.
• Banking system consolidated, with more foreign
  entry and supervision tightened (help of WTO,
  FSAPs).
• Fiscal position improved, gradual removal of
  exchange controls and build up of reserve
  holdings to reduce risks of external shocks.
• Exchange rates more flexible, but
  Samuelson-Belassa effect showing up in revival of
  asset bubbles, plus inflation. Real effective
  exchange rates are rising due to faster growth.
• Asian financial integration increasing, but slow
  due to political and other differences.

23
Asian Domestic Financing Profile Equity
Financing (42) Overtook Money Financing (37)
in 2007
42
37
Source Asian Bonds Online
24
Still Lack of Depth in Many Asian Capital Markets
Source Exchange Collaboration and Joint
Operation in South-East Asia , McKinsey Co,
July 2007
25
Asia Half of World Population but Quarter of
Equity Market, 2006
Composition of World Population by Region
Composition of Global Market Capitalization by
Region
Source IFS, and CIA World Factbook
26
Shallow Debt (Credit Bond) Financing in Most
Asia Countries (US billion)
Source Asian Bonds Online
27
Transaction Costs in SEA Equity Markets More Than
Double Those in US and Europe
28
Average Intermediation Costs (Money Market
Spread) in Asia is Relatively High (3.12, 2006)
Japan has lowest intermediation cost of 1.54 in
2006
Intermediation Cost (Lending Rate Money
Market Rate)
Source IFS, IMF
29
III. Financial Stability Robust Real Sector
Robust Financial MarketsThinking through
how to regulate
30
Scope of Financial Regulation

• What is Financial Regulation
• Who do we regulation?
• Why do we regulate?
• How do we regulate?

31
Objectives of Financial Regulation

• The goal of financial regulation is to influence
  the behaviour of intermediaries so that the
  policy objectives are achieved.
• Regulatory Cycle
• Policy Objectives ? Processes ? Policy Outcomes
  ? ? Policy Review
• Regulation is more art than science, since market
  behaviour changes with time and innovation

32
Why Regulate?

• Protection of investors - asymmetric
  information, unclear rules, and misconduct of
  intermediaries may lead to losses for investors
• Risky behaviour of financial intermediaries
  could cause failure that either lead to contagion
  or financial crisis
• Financial misconduct by issuers and
  intermediaries creates social loss and lack of
  market confidence on a level playing field

33
What is a Market?

• People, exchanging
• Products property rights, using
• Process, e.g. trading, clearing, settlement
  software, across
• Platform - hardware infrastructure/network
  carrying messages, under
• Prudential Rules of the Game that protect the
  property rights.

34
Principal Features of Financial
MarketsIdentifying problems

• People Are the people misbehaving?
  Enforce
  discipline
• Policy Is the policy wrong?
  Review
• Products Are the products defective?
  Define
  property rights
• Prudential framework Is the prudential framework
  bad?
  Reform
• Platform and Process Is the process obsolete?
  
  Upgrade

35
Efficient Markets require

• Liberal Entry of Participants and Products
• High transparency low information asymmetry
• Efficient Operations by solvent participants
  under international rules of the game at low
  transaction costs
• Low incentive distortions that moves market in
  unhealthy direction e.g. moral hazard or
  subsidies
• Efficient regulation at low regulatory costs
• Orderly exit of insolvent participants obsolete
  products and insolvent operators create huge dead
  costs on market

36
Source FSAP Experience and Issues Going
Forward, Stefan Ingves, Economic Forum, 16
December 2003
37
Types of Financial Regulation

• PRUDENTIAL REGULATION ensuring that market
  participants have adequate capital and liquidity
  and are fit and proper (e.g. banks operate
  soundly)
• CONDUCT REGULATION ensuring that market
  participants behave within ethical and statutory
  rules that does not impose harm on market (e.g.
  insider trading, connected lending)

38
Malcolm Sparrow - The Regulatory Craft

• Pick important problems, fix them and then tell
  everybody.
• The essence of the regulatory craft lies in
  picking the right tools for the job, knowing when
  to use them in combination, and having a system
  for recognizing when the tools are inadequate so
  that new ones can be invented.
• Professor Malcolm Sparrow, The Regulatory Craft,
  Harvard University, 2000

39
Braithwaite Regulatory Pyramid
Each regulated group can be divided into
behavioural segments
Regulatory Response
Source Adapted from work of Prof. J.
Braithwaite, ANU
40
Policy, Process and Outcome
41
Regulation is Trade-off between Gains versus
Risks or Costs

• Cost of Regulation
• Resources spent to apply it Burden Imposed on
  Firms Law of Unintended Consequences
• Benefits of Regulation
• Reducing market failure and externalities
• Preventing bad behaviour
• Zingales necessary to do an overall calculation
  of the overall benefits of regulation versus its
  overall costs
• Need framework to work out Policy Options
  Standards to measure costs and benefits

Luis Zingales, The Costs and Benefits of
Financial Market Regulation, European Corporate
Governance Institute, April 2004
42
To Reform or Not Reform
High incidence of market misconduct and fraud.
Impose more regulation to punish perpetrators and
deter future misconduct.
No market misconduct or fraud. Little or no
regulation required. Market and issuers exercise
self-discipline.
Benefit of regulation lt costs of regulation
Dont reform
Benefit of regulation gt costs of regulation
Reform
43
Policy Option Matrix who gains, who loses?
44
Why do We regulate Banks?

• Resource Allocation As the primary custodian of
  Public Savings, efficiency and stability of banks
  key to efficiency and stability of economy
• Monetary Policy Banks are both the channels of
  monetary policy and operators of the payment
  system
• Risk Intermediary Banks have fundamental
  maturity and liquidity mismatches, prone to
  contagion and systemic collapse
• Asymmetric Information Outsiders do not know
  how to assess bank quality
• Consumer protection interface with retail at
  all levels
• Competition To ensure innovation and no cartel
  behaviour

45
Bank Fragility Maturity Mismatch

• Banks are fundamentally illiquid - they borrow
  short and lend long
• The average maturity of bank liabilities (mainly
  deposits) can be less than 6 months, tending to
  zero when there is a bank run.
• The average duration of bank loans are
  significantly longer (especially mortgages or
  corporate debt), because in times of crisis,
  borrowers delay repayment. Average duration of
  15-30 year mortgages is around 6-7 years
• Hence, banks have to maintain high liquidity and
  there is a Lender of Last Resort function at
  central banks to provide emergency liquidity.
• Banks must manage their liquidity better through
  securitization and asset and liability
  management.

46
Bank Information Asymmetry

• Depositors and even regulators have difficulty
  judging quality of bank assets
• Bank assets, especially long-term loans, are hard
  to evaluate as to value, due to illiquidity,
  valuation of collateral, solvency of borrower,
  real interest rates and market conditions.
• Because banks are operators of the payment
  system, defaults of large customers can lead to
  their own defaults - settlement risks.
• Banks are also highly leveraged

47
Banks are prone to Crisis (cost of resolution)

• US Savings Loan failures (1981-3) - 5 of GDP
• Scandinavia (4-11 of GDP)
• Latin American (late 1980s and early 1990s)
  5-55 of GDP
• Russia and Eastern Europe (early 1990s) - 5-10
  of GDP
• Japan (15 of GDP)
• East Asian crisis (21-55 of GDP)
• SubPrime Crisis - US1 trillion?

48
Bank Regulation and Supervisory Process

• Entry Licensing
• Bank Regulation - Off-site surveillance, policy
  formulation and bank-regulator relationship
• Bank Supervision or Examination - On-site
  Examination and Inspection to determine the
  following-
• Determination of financial position and quality
  of assets and liabilities
• Assessment of Quality of Corporate Governance,
  Internal Controls, Risk Management, and
  skills/experience and integrity of staff.
• Exit - Orderly winding up through Deposit
  Insurance Scheme

49
Approaches to Bank Supervision

• Self Regulation through bank associations and
  better corporate governance
• Greater Disclosure
• Prudential Measures - Capital Adequacy and
  Liquidity Rules BASLE I II
• Corporate Governance
• CAMELOT Ratings
• Off-site Surveillance and On-site Inspection
• Enforcement and Exit Processes

50
US CAMELOT Rating

• Capital Adequacy - meeting Basle requirements
• Asset Quality - Loan Classification
• Management Quality - fit and proper persons,
  corporate governance
• Earnings Quality - ROE, ROA, cost ratios
• Liquidity - Asset-Liability management
• Operational Risk - how good are the operations
  and controls?
• Technology - ICT management, infrastructure and
  risks

51
1988 Basle 1 Capital Adequacy

• Weighted Risk-Asset Ratio, minimum 8 of risk
  assets, comprising two tiers
• Tier 1 or core capital issued capital
  retained earning (minimum 4)
• Tier 2 capital, including subordinated debt all
  other capital general loan loss reserves plus
  unrealized surplus on stock holdings by banks
• Japan insisted that unrealized surplus on stock
  holdings by banks should be included as
  supplementary capital (this turned out to be
  serious mistake).

52
Basle II Capital Accord

• Allows banks to use own models to evaluate risks
• Three Pillars
• Minimum capital requirements for credit risks,
  operational risks and market risks
• Discretion to national authorities to fine-tune
  capital requirements
• Greater disclosure and transparency.

53
Three-dimensional changes in Asias banking system

• Asian banks have been substantially restructured
  since the 1997-98 crises.
• Corporate sector disintermediation is accompanied
  by increased household intermediation.
• Region has seen rapid entry of foreign banking
  services.

54
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55
Significant changes in bank intermediation

• Corporate sector is moving away from bank credit
  a process driven by large profits,
  de-leveraging and the growth of domestic bond and
  equity markets.
• Banks are rapidly expanding credit to the
  household sector both cyclical and structural
  forces are contributing to this expansion.
• Flexible exchange rates and interest rates are
  posing huge market risks for Asian banks,
  especially since they hold large amount of
  securities.

56
Nature of Bank Losses
Credit losses Excessive regulatory fiscal
taxes Speculation Losses (Market risks)
Operational Risk losses (bad internal
controls) Fraud Excessive Overheads
(inefficiencies or incompetence)
57
Banking Crises and Resolution

• Crisis is an event, the culmination of many
  factors interacting together
• Bank restructuring and resolution is a process
• Process involves four major steps
• Diagnosis
• Damage Control
• Loss Allocation
• Rebuilding Profitability and Getting the
  Incentives Right
• How have we performed since Asian Crisis?

58
What is a Financial Crisis?

• The eruption of an event (eg failure of a
  corporation or financial institution) that
  triggers a systemic distress, panic or wealth
  loss that spreads within domestic markets or
  abroad
• Crisis are caused by internal frailties or
  weaknesses that allow systemic breakdown as a
  result of internal or external shocks
• Because financial system is a network, need to
  distinguish between liquidity crisis flow from
  solvency crisis stock
• Banking system needs lender of last resort,
  precisely because Central Bank can step in to
  prevent a liquidity crisis from triggering a
  solvency crisis.

59
Stocks and Flows of National Economy

• Financial system is blood circulation system of
  National economy. Financial network links the
  following four real sectors together
• Corporate sector
• Household sector
• Public sector
• External Sector
• Each has its own balance sheet and flow problems
• Crisis occurs when weaknesses in real and
  financial sector are exposed by event/shock in a
  vicious circle

60
1996 Negative Net Investment Position (NIP) and
Exchange Devaluation explains a lot about Crisis
Source calculations from Lane and
Milesi-Ferretti, 2006
61
Importance of Macro and Balance Shet Numbers on
Financial Stability US Flow of Funds data 2007
(Fed)

• US External Position GDP 13.8 trn, Net current
  account deficit 5.1 of GDP, gross external debt
  13.4 trn (97 of GDP). Net International
  Position 2.44 trn or 17.7 of GDP (-22.6 in
  2004)
• Fiscal deficit 2.7 of GDP and debt held by
  public 36.6 of GDP. If Agency debt of 5.3 trn
  is added, total US Government debt would rise to
  75.4 of GDP.

62
US Current Account Deficit
63
How Bank Capital is ErodedIMF Article IV for
USA, July 2008
64
Balance Sheet of Households and Corporate Sectors
must be watched

• Households Total Real Estate Assets 22.5
  trn, total financial assets 45.3 trn
  Liabilities 14.4 trn (mortgage 10.5 trn,
  consumer credit 2.6 trn, net worth US57.7 trn.
  
• Corporate Total Real Estate US8.9 trn, Total
  Financial Assets US12.9 trn, Net Liabilities
  US11.3 trn, Net worth US16.1 trn.

65
Impact of Changes in Equity and Real Estate
Prices - 2007

• Total stock market US16.9 trn (91 of GDP)
• Total real estate (households corporate)
  US31.4 trn (228 of GDP)
• If equity market falls 20, then losses would be
  3.4 trn or 24.5 of GDP.
• If real estate prices fall 20, losses would be
  6.3 trn or 45.5 of GDP.
• Decline in 1Q2008 for household net worth was
  1.7 trn, equivalent to 2.9 of total net worth,
  but 12.3 of GDP.

66
Impact on Financial Sector

• Estimates from the Spring 2008 Global Financial
  Stability Report, using prevailing market prices,
  put losses at near 1 trillion globally and
  220260 billion for U.S. banksover one-third of
  the equity of the ten major commercial and
  investment banking groups. Of this, some 160
  billion in U.S. losses have already been
  recognized. - US Article IV
• 2007, gross credit assets of US financial sector
  was 35.8 trn, of which capital of 4.6 trn or
  12.8 of assets (excluding derivatives).
• Of credit assets, 14.1 trn was mortgages, 2.4
  trn was consumer credit, 10.2 trn was corporate
  bonds and loans, 6.2 was GSE and agency paper.
• If credit losses exceed 15, capital of financial
  system would be wiped out.

67
Vicious Cycle of Financial DistressAsian
crisis private debt mismatchesLatin American
crisis excessive public debt and inflation
68
Ultimately, Financial Crisis ends up as
quasi-fiscal deficit

• Banks have implicit or explicit deposit
  insurance, ie moral hazard risks
• Depositors or foreign creditors cannot absorb
  losses without huge political implications
• Both banks or borrowers can be Too Large to
  Fail government is concerned that failure can
  have systemic problems
• Hence, banks or borrowers transfer their stock or
  flow losses to the Government via Government
  guarantees, Asset Management Companies (AMC), or
  bail-outs
• Relationship is known as Troika model
• NPLs and bank rescue trigger feedback effects in
  a vicious circle that destabilises monetary and
  fiscal situation, resulting in capital flight

69
Crisis have both Macro and Micro Origins

• Poor macro policies, eg fiscal deficits,
  inflation, balance of payments deficits
• Weak institutional structures
• Lack of deep debt and capital markets
• Lack of credit culture
• Outdated laws, weak judicial systems
• Poor corporate governance
• Lax enforcement, poor risk management, connected
  or directed lending, weak loan recovery, deposit
  guarantees, and distorted tax policies all show
  up in weak balance sheets
• Insufficient attention to Trade Cycle and Asset
  Bubbles

70
How good is diagnosis?

• Institutional strengthening
• Coordinated surveillance by IFIs, FSF, FSAP
• International standards set by BIS, IOSCO, IAIS,
  IMF
• Strengthened supervisory framework and
  cooperation at national and international level
• Adoption and implementation of international
  standards by local networks would strengthen
  overall network, eg IAS, OECD corporate
  governance Codes, insolvency laws
• Generally getting better at diagnosis, but
  informational difficulties remain
• Asset valuation is difficult as there are no
  market prices for loans
• Collateral valuation also serious problem in
  estimating provision needs
• Inadequate provisioning due to tax changes that
  need reform
• Banks generally reluctant to reveal extent of
  losses, unless forced by crisis or incentive to
  shift loss to AMC
• NPL estimates by market vary and at least double
  official data

71
Damage Control

• Because NPLs derive from real sector exposures,
  they can be minimized in two ways-
• (a) Restrict further bank lending (quick fix)
• (b) Work on changes in corporate governance and
  debt recovery (long haul solution)
• You must stop both the stock and flow losses
• Faster IFI response with better recognition that
  no one size fit all solution can apply
• Selective bank closures or foreign entry helps to
  keep domestic banks on their toes
• The fact that NPLs have been reduced in some
  economies does not mean that they will not revive
  if structural issues (eg poor borrower solvency,
  connected lending, weak corporate governance,
  policy distortions, political instability) are
  not resolved.

72
Loss Allocation

• Political economy of loss allocation Who
  should bear loss shareholders, borrowers,
  banks, employees, depositors, external creditors,
  government? Ultimately, state bore most of losses
  
• Liquidate or restructure banks market solution
  or government intervention? Mixed approaches
  closures, mergers, nationalisation, foreign
  investment and government bailouts
• Key concern is fiscal sustainability since
  unresolved NPLs, as quasi-fiscal deficits
  increases contingent liability of budget and
  therefore become potential future tax burden

73
Fiscal Sustainability- inflation, growth and
budget

• Fiscal sustainability of debt, and hence success
  of bank restructuring, depends on rate of
  inflation, growth and level of budget deficit.
• The change in government debt to GNP ratio (d)
• Change in d (primary deficit/GNP)
  (seigniorage/GNP)
• d (real interest rate growth rate)
• Low inflation, high growth and low fiscal
  deficits or small surplus economies will see d
  decline over time. E.g. Malaysia, Spain and
  Chile
• Large primary deficits and excessive real
  interest rates result unsustainably huge debt
  ratios, leading to hyperinflation. E.g.
  Argentina and Yugoslavia
• Change in d also depends on whether NPLs are
  checked and bank losses stemmed

74
Building Market Economy means building a Robust
Property Rights Infrastructure (PRI)

• 1. Delineation of property rights
• Property rights need to be clearly defined and
  legally protected
• 2. Enforcement of property rights
• Property rights need to be protected and enforced
  efficiently, fairly, and predictably through
  independent judiciary and regulatory systems
• 3. Culture in respecting law, property rights and
  contracts
• Credit culture means respect of law, property
  rights and contracts, and they are rewarded for
  doing so
• 4. Reform market institutions that protect rights
• The accounting, regulatory, judiciary and
  property registration (eg land and equity
  registration systems) need to brought up to
  international standards in order for markets to
  perform efficiently, fairly and transparently

75
Efficient Markets Have Robust PRI Institutions

• Central Registry of property right e.g. land
  registry, share registry
• Trading Engine e.g. stock exchange
• Clearing, settlement and payment infrastructure
  clearing house and payment system
• Regulated intermediaries
• Clear Rules of Game norms, standards, codes,
  regulations, law
• Enforcement infrastructure enforcement costs
  cannot exceed benefits to market
• Independent and transparent judiciary to
  adjudicate property disputes
• ? Effective judiciary, enforcers police,
  regulators, enforcement agencies, accounting,
  legal and financial intermediaries are all part
  of PRI

76
Process to Manage Reform

• Asia has implemented many reforms, but outcomes
  may not always be on target.
• Reform fatigue could have set in resulting in no
  follow through to ensure successful
  implementation.
• Law of unintended consequences may frustrate
  reform efforts and generate reform resistance.
• Reform is a process, but we need a process to
  manage the reform process so that it stays the
  course and departures from path can be put back
  on track through set procedures.
• Reform needs ownership of the need for change.
• Process to manage change is an important area
  that deserves more attention by policy makers.

77
Use Different Levels of Discipline

• Self Discipline - self regulation, using market
  standards and codes
• Regulatory Discipline - enforce fairly and
  transparently
• Market Discipline - use courts, competition and
  transparency
• All three disciplines are necessary to achieve
  good corporate governance and efficient markets

78
Getting the Incentives Right

• Financial crime and bad intermediary conduct
  thrive when there is no regulatory credibility
  that they will be caught
• Regulatory credibility depends on effective
  surveillance, speedy investigations,
  well-prepared prosecutions and appropriate
  sanctions
• Justice must not only be done, but seen to be
  done there must be clear and transparent due
  process in investigation and the disciplinary
  process
• Enforcement Key to Regulatory Discipline

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Sparrows 6 Themes ofRegulatory Practice

• Cut obsolete regulations
• Reward results, not red tape
• Get out of your office and create
  regulator-regulatee partnerships
• Negotiate, do not dictate
• Reduce regulatory reporting burdens
• Search for results that count

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• Thank You
• Address questions to as_at_andrewsheng.net