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Policy: Effects of Globalization Financial Institutions Need Regulation that Keeps up with Change

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
May 2007
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The expansion of financial institutions across borders has accelerated significantly in the past decade in both banking and other areas of finance. But regulation and supervision have not always kept pace. In banking, where there are more data to examine, the globalization of institutions has brought benefits to financial stability but may have changed the nature of the remaining risks. For individual financial institutions, geographic diversification has meant less volatile income and asset values, reduced exposure to domestic markets, and improved access to foreign markets. There are also broader financial sector development and efficiency benefits for many countries—especially emerging markets, which have benefited from knowledge and technology transfer. An open question, however, is what would happen to global and national financial stability if severe adverse events occurred, given banks’ increased cross-border expansion. The April 2007 Global Financial Stability Report examined the potential risks and implications for regulators.

Although global banking systems have weathered a number of shocks in recent years, they have, fortunately, not been tested by more extreme shocks that threaten to spill across borders, institutions, and markets. A relatively small number of large institutions are playing a leading role in local and international financial markets, which could increase the spillover effect of any large shocks. This is not only a global issue involving the largest institutions; it is also an important regional and national issue and one that touches even smaller banks that operate internationally. Some indicators suggest that increased institutional globalization could hasten ripple effects across borders, reflecting either increased exposure to common shocks or institutional spillovers from ownership, trading, or other linkages. For example, implied market expectations of loss rates are higher for internationally diversified large banks as a group than they are for all large banks, including less diversified banks, as a group. Unlike measures that look at financial institutions individually, those that look at groups of banks allow for correlations between the institutions’ expected losses.

Strengthening supervision

The nub of the issue for policymakers is the mismatch between the scope of institutions’ activities, and the legal, regulatory, and supervisory frameworks. This mismatch can be particularly problematic when foreign banks’ activities are large and important for a host country. The problem is only partially resolved if a foreign bank operates as a locally incorporated subsidiary rather than as a branch. Although such an arrangement gives host authorities greater supervisory control over local operations, it may not guarantee access to relevant information or the ability to respond promptly and effectively in a crisis. One key policy challenge is ensuring effective cross-border coordination between home country and host country regulators in the ongoing supervision of cross-border banks and in crisis management arrangements. Surveillance of financial system risks thus needs to cover globalized banks’ systemic issues as well as the regional issues that arise when such banks are involved in several host countries.

Various challenges for cross-border supervisory and crisis management cooperation arise from legal, political, and cost constraints. In many countries, there are wide differences in legal powers and objectives, relative expertise and resources, risk preferences, and deposit protection and insolvency frameworks. Similar constraints will likely make it difficult to predetermine the division of any loss or burden sharing between the authorities in the home and host countries if a cross-border institution fails. Still, although these constraints are important considerations, significant work is under way to improve collaboration in both crisis prevention and crisis management, especially in major financial hubs and in Europe. This reflects the importance of the most significant global institutions. Such work needs to continue and be undertaken more broadly.

The options that may be appropriate for collaborative processes in different circumstances range from ad hoc discussions on issues of mutual interest to shared reliance on the performance of tasks and the delegation of authority. Improved mutual understanding and confidence building are cornerstones of future success. Ongoing joint crisis-simulation exercises will further increase awareness and the commitment of both supervisors and national authorities. The continuing evolution and application of international supervisory and other standards, and the convergence of good practices, should help make national arrangements and policies more transparent and easier to understand—within and between countries.

Jorge Chan-Lau and Mark Swinburne

IMF Monetary and Capital Markets Department

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