Question

What can emerging market countries do to strengthen prudential regulation and supervision of their banking systems?

How might these steps help avoid future financial crises?

Answer 1

Policymakers and analysts are still sifting through the wreckage of the Asian financial crisis of 1997 and the subsequent crises in Russia, Turkey, and Argentina to discern key lessons so that similar crises will not recur. Some lessons are by now well understood. Pegged exchange rates can encourage excessive borrowing and expose countries to financial collapse when foreign exchange reserves run dry. Inadequate disclosures by both private companies and public bodies can lead to similar dangers.

Although many factors undoubtedly contributed to these crises, it is now widely recognized that each suffered from a failure in “governance,” and in particular a failure in governance in their financial sectors.

In its broadest sense, governance refers to the range of institutions and practices by which authority is exercised.

The special emphasis placed on the financial sector reflects the unique character of financial intermediaries, and the added complexity of standard governance problems in the financial sector. For example, questions of transparency, incentive conflicts, and agency conflicts in the corporate sector are compounded by greater opacity, government ownership, and regulation of financial institutions.

Another reason to focus on governance in the financial sector is that the costs can be severe when governance is poor. Every one of the major economic crises in emerging market countries in recent years—in East Asia, Russia, Turkey, Brazil, and Argentina—has been accompanied or has been triggered by a crisis in its financial sector, and in the process, the citizens have suffered deep pain. In the case of Indonesia, which was hit hardest during the Asian financial crisis, the fiscal costs alone of having the government step in to make good on the obligations of the privately held banks exceeded 100 percent of the country’s Gross Domestic Product (GDP). Financial crises also typically entail large social and economic costs, which are visited not only on the wealthy who have something to lose, but also throughout the populations of countries where employment opportunities dwindle and wages collapse when GDP drops sharply and currency values plummet.

The costs of financial crises are not the only reasons for being interested in the governance of the financial sector, however. Poor governance is also typically associated with corruption, which not only corrodes the trust individuals have in their private and public institutions, but also acts as a significant deterrent to foreign direct investment (FDI). Governments can use their state-owned institutions to support excessive government spending and to favor borrowers that are less than creditworthy. In addition, governments often operate their institutions, or the regulatory processes that govern them, in ways that discourage the development of vibrant private sector competitors. For all of these reasons, there was support voiced at the conference for efforts by governments that continue to own banks to privatize them.

Collective investment schemes—which enable investors to own proportionate shares of a pool of financial assets—have become increasingly important financial institutions in developed countries. The governance structures of these institutions vary widely. Corporate style mutual funds, found mostly in the United States and a few emerging markets, dominate in terms of value of assets. Contractual and trust type structures dominate in terms of the number of funds, and are found mostly in countries where joint stock company laws do not permit firms to continuously issue and redeem their own shares, or where liquid markets to manage open-ended schemes may not be well developed.

One improvement might be a requirement that certain kinds of corporate transactions, especially those involving controlling shareholders, be approved by a majority of the minority shareholders. Another participant suggested having specialized courts with expertise in corporate law. Finally, given the economic importance of the financial sector and the dangers when it functions poorly, it is not surprising that governments in both developed and emerging market countries alike take a keen interest in regulating and supervising financial institutions and markets.