VI. Policy Implications and Conclusions

International Monetary Fund
Published Date:
September 1996
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Assessment of Recent Developments

The evolution of international financial markets since the early 1990s, as well as more recent market developments, provide some tentative evidence that international markets and their major participants—financial intermediaries and their supervisory authorities—are settling down into a more steady pattern of growth and innovation. It should be expected that international markets will continue to become more global and more dominated by institutional investors, that the continuing international diversification of institutional portfolios will mean that the exposure of these investors to emerging markets will grow along trend, and that the spread of global derivative finance will continue. This evolution will take place against the backdrop of improved risk management in the international banking sector, strengthened market surveillance within an adaptive regulatory environment, a more resilient market infrastructure, and with an official sector that has made it a lop policy priority to create the infrastructure required for a stable market environment.38

On the private side of the markets, there is evidence, at least for now, that lessons have been learned from the losses in the first part of the decade in banking, derivative, and global bond markets, and in emerging markets. Extensive discussions with market participants and supervisors in the major financial centers, supported by evidence on recent market developments, confirm the view that market participants, including the risk-tolerant hedge funds, have become more risk aware and are applying greater discipline in risk-managing their financial positions. Market participants confirm that derivative markets have matured, with participants shying away from the more exotic options-related structures in favor of plain vanilla futures, options, and swaps-type of risk-management instruments. Highly leveraged positioning across the major international markets by the risk-tolerant institutional investors, which contributed to the turbulence in global bond markets in early 1994, seems to have been reduced somewhat. It appears, therefore, that there is a relatively lower risk that an upward adjustment in U.S. interest rates could precipitate another round of major losses for international financial institutions, such as the one in early 1994, Likewise, banking systems in the major industrial countries, particularly in the United States, have made significant progress in improving their performance, although some important problems remain in several of these countries.

All of this is not to say that financial turbulence, stress, and crises will not reappear in the future. Indeed, it is to be expected that some of the hard lessons learned in recent years may again be forgotten and that the more cautious behavior witnessed now may give way to renewed bouts of exaggerated optimism. But, at least for now, international capital markets appear to have become more resilient and are less likely to be a source of disturbances.

The most dramatic turnaround took place in the emerging markets. Aggregate flows to emerging market countries in 1995 have surpassed the previous peak reached in 1993, after the slowdown in the immediate aftermath of the Mexican crisis. Furthermore, investors appear to have become more discriminating among regions and countries, and in the type of investment. For example, in 1995 foreign direct and portfolio investment flows to Asian developing countries increased by more than 22 percent, while such flows to Latin America declined by the same percentage. Similarly, while net foreign direct investment flows to developing countries increased by 17 percent, net portfolio flows fell by 27 percent. In short, there appears to have been a change in the attitude of investors toward emerging markets. The optimism of the first half of the 1990s has given way to a more cautious and deliberate approach. The diversification of institutional investment portfolios can be expected to continue along this trend in the coming years, with the volatility in flows coming from the more opportunistic investors and from investors reacting to cyclical developments in yields in the industrial countries, particularly in the United States, There is some tentative evidence that the quality of data and investment research has improved, and that investment decisions are taken more carefully, which might serve to reduce volatility in flows. The IMF’s new standards for improving the quality and dissemination of economic and financial data will be helpful in this regard.

One notable feature of the composition of flows to emerging markets is the growth of yen- and deutsche mark-denominated bond issues. It appears that the sovereign borrowers do not always hedge the currency risk incurred with these issues, preferring instead to reap the immediate positive benefits, including fiscal, from the relatively low-interest coupons on these obligations. Given the potential for an increase in the local currency value of these obligations in the event of an appreciation of the yen or the deutsche mark, these positions will have to be monitored carefully and managed. Increased disclosure of relevant financial information by the issuing countries is important to allow rating agencies and investors to arrive at an appropriate assessment of the risk of such issues.

It is widely recognized that the efforts being made to improve the health of the banking systems in some of the emerging markets are key to improved future economic performance, and foreign investors appear to be paying much more attention to the soundness of a recipient country’s financial system as a key variable to consider in their investment decisions. Indeed, the soundness of the financial sector has become one of the economic fundamentals. Once bank balance sheets have been cleared of nonperforming loans, then the emphasis will have to shift toward improving the regulatory and market infrastructure and strengthening the surveillance of financial sectors.

Broadening the Surveillance or International Financial Markets

The efforts in the Group of Ten countries, since the Basle Accord in 1988, to improve the surveillance of international financial markets are generally perceived as having been successful. While the onus is still on supervisory authorities, the shift in focus from prudential ratios to risk management, although still in its infancy, will allow the regulatory framework to deal flexibly with innovations in instruments and techniques. In addition, the Basle Committee on Banking Supervision has through successive revisions of the Basle Concordat delineated the supervisory responsibilities of home and host supervisors, established minimum standards governing the supervision of international banking firms, and developed the modalities for the exchange of supervisory information. The Committee has been successful in creating a “community of supervisors,” who through a process of education, analytical work, and consultation with market participants have forged agreements on a broad spectrum of contentious issues. However, a number of challenges still remain. One of the most important among these challenges that will need to be addressed in the near future by the major industrial countries is how to extend and broaden current arrangements for formulating and implementing surveillance over international banking markets to include a growing number of systemically important emerging market countries.

As the brief review in Section III indicates, emerging market countries have been prone to banking problems; the problems have been costly, and they have the potential to spill across national borders. Hence, the extension of international supervisory arrangements to include emerging market countries is important not only to safeguard the stability of the international financial system, but also to increase the effectiveness of the surveillance over domestic banking institutions in emerging markets. The growing internationalization of the financial sectors in emerging market countries—including increased access to offshore derivative transactions for the purpose of blunting the impact of domestic financial regulations—also implies that a supervisory approach with a national focus will be inadequate. Furthermore, the extent to which the emerging market countries will be integrated into the international financial system will depend largely on their success in raising supervisory standards and the risk-management capabilities of internationally active financial firms to international standards.

Closer integration of the supervisory authorities in emerging market countries into a cooperative international arrangement for the supervision of international banking markets would have at least five main benefits; it would facilitate the surveillance over international banks on a consolidated basis—a necessary condition for the effective supervision of the banking sector; it would facilitate a broader and more intensive exchange of relevant supervisory information; it would create a cooperative atmosphere helpful for the quick resolution of financial crises; it would provide the emerging market countries with an opportunity to have their views reflected in the formulation of international agreements in the supervisory and regulatory area; and membership in an international arrangement and the possibility of being identified as not being in compliance with international standards would provide increased authority and incentives for supervisors to achieve a timely and credible implementation of internationally agreed regulatory and supervisory standards.

The first step in constructing a more comprehensive international arrangement for the supervision of international financial markets should be the formulation of international regulatory and supervisory standards, covering, at a minimum, the consolidated supervision of international banks, capital requirements, provisioning rules, exposure limits, and the authority of supervisors over all aspects of the operations of financial institutions. These standards should be viewed as pro-viding a minimum baseline of regulatory and supervisory constraints on the banking system, but they need not be regarded by all countries as sufficient. Countries will want to tailor their standards to reflect local conditions. The effectiveness of such standards in strengthening the stability and performance of banking systems depends crucially on the ability and willingness of the authorities to implement these standards. Furthermore, it is widely acknowledged that there needs to be a credible mechanism for assessing compliance with agreed standards. In order to allow market forces to play a supporting role in the implementation of agreed standards it is desirable to make such assessments available to the relevant audience, as is the case, for example, with the risk-weighted capital standards and with the Group of Thirty standards for securities settlement systems.

Risks in the Global Foreign Exchange Market

Another issue of systemic importance is the growth of turnover in the international foreign exchange markets and the associated increase in settlement risk. Turnover in this market has risen to $1.2 trillion daily, with much of it concentrated in a handful of international dealing banks. The risk of disruption in this market arises when a major participant fails to pay out the currency it sold although it already has received the currency it bought. Furthermore, there is also the risk that doubts about the ability of a major participant to complete its payments obligations may lead other participants to withhold payment to this participant for currency they already received. The failure to deliver could leave the first counterparty without sufficient means to make subsequent payments to other market participants. A number of private initiatives to reduce settlement exposures, involving bilateral and multilateral netting and clearing, are under way, including the establishment of a multilateral payments, clearing, and settlement institution. The significant reduction of foreign exchange settlement risk, whether done entirely in the private sector or through public sector initiatives, will make foreign exchange transactions more expensive. Given the highly competitive nature of the foreign exchange market, there is little hope that market participants will succeed in constructing foreign exchange settlement arrangements without supporting measures from the central banks.

Although central banks in the major industrial countries have been deeply involved in reducing risk in national wholesale payments systems, they have not played a comparably active role in reducing settlement risk in the foreign exchange markets. However, the size and the systemic importance of the foreign exchange market make the involvement of central banks in this area important. Vigorous efforts will need to be made to facilitate the ongoing private efforts at reducing settlement risk. First, the main wholesale payments systems in the major countries will need to continue to move toward real time gross settlement. Second, central banks will need to be flexible in ensuring overlapping business hours for the world’s wholesale payments systems. Third, reforms of the relevant statutes will have to guarantee that the various bilateral and multilateral netting schemes are recognized during bankruptcy proceedings. Finally, in the event that the private sector fails to make satisfactory progress in reducing settlement risk, it may become necessary to consider the possibility that dealers be required to hold capital against their settlement exposures.


As noted in the communiqué of the June 1995 Halifax summit of the heads of state of the Group of Seven countries.

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