Abstract

Over and above these measures, there may be a role for prudential measures designed to limit excessive dependence on short-term foreign currency debts.

Over and above these measures, there may be a role for prudential measures designed to limit excessive dependence on short-term foreign currency debts.

Basic Principles

In a first-best world, banks and other financial market participants would have proper incentives to manage risk, and this would help avert a concentration of risks with the potential to endanger systemic stability. The tendency to take on excessive risk would be contained through the operation of market discipline, facilitated by the adoption of best-practice accounting, auditing, and disclosure standards.58 Public policy can help create the appropriate environment both by mandating the use of proper accounting, auditing and reporting rules for financial institutions and by taking care not to create a culture of implicit guarantees so that lenders face a significant loss of capital if they fail to assess credit risk prudently.

Where the techniques of risk management are not well developed, where auditing and accounting practices are inadequate, and where other distortions interfere importantly with banks’ ability to manage risk, there is a particularly important role for firm prudential regulation. The argument for prudential regulation is even stronger insofar as central banks and governments backstop financial markets, and their provision of a financial safety net encourages banks and other market participants to take on excessive risk. A century and more of historical experience points to the need, in most countries, for central banks to provide lender-of-last-resort services to prevent illiquid financial markets from seizing up in periods of generalized distress. As noted earlier, this backstopping function, though essential, is a source of some moral hazard. The appropriate response is rigorous prudential supervision and regulation combined with careful design of the lender-of-last-resort facility to limit the scope and incentives for financial market participants to take on excessive risk.

Problems of Definition and Design

In the industrial countries, prudential regulation of banks has been evolving from simple rules prohibiting or placing ceilings on certain types of investments and limiting assets to a certain proportion of capital, in favor of more complex regulations that attach different weights to different assets according to their risk and typically use sophisticated models to calculate the weights. Increasingly, banks are allowed to use their own proprietary models in deriving the weights. Overall, prudential regulation appears to be shifting toward broad oversight of institutions’ capacity to manage risks and away from narrow administrative measures.

The complexity of this new approach pushes the envelope of competence for bank regulators and managers even in the countries with the most advanced financial markets. The point applies with even more force in emerging markets. Insofar as this is the case, there is an argument for continuing to rely on simple rules, at least until the expertise is in place to implement more demanding approaches.

Where some of the relevant risks are associated with excessive reliance on certain categories of capital account transactions, this is an argument for containing those risks through the imposition of capital, liquidity, reserve, and open position requirements that take into account the systemic-risk implications of all the entries on the asset and liability sides of bank and nonbank firms’ balance sheets59 and specify optimal risk weights for each item.60 Regulators have traditionally distinguished between open position limits and differential capital requirements on the one hand—which are generally regarded as prudential measures, and as consistent with the Basle Core Principles—and differential reserve requirements on the other, which have traditionally been regarded as devices to enhance monetary control. While it may be tempting to dismiss the point as a semantic one, it highlights a substantive issue—namely, that policymakers wishing to limit capital account transactions for other reasons (to reconcile otherwise incompatible internal and external macroeconomic objectives, for example) may invoke arguments based on prudential regulation as cover for policies otherwise at variance with their stated goal of capital account liberalization.61 Given that these types of policies typically have complex consequences, there is no easy way to determine which policies have a primarily prudential objective.

In fact, policies to contain the risks associated with capital flows have been designed and implemented in a variety of ways. Some countries differentiate reserve requirements according to both the residency and currency of the denomination of deposits, while others differentiate them on the basis of the currency of denomination but not residency.62 In still other cases, prudential measures have been keyed to banks’ open net foreign currency positions, a net open position being the difference between unhedged foreign currency assets and liabilities (in principle, comprising both net spot—balance sheet—and forward—off—balance sheet—positions), typically as a percentage of the bank’s capital base. In Chile, the Czech Republic, Egypt, Hungary, India, Poland, and Turkey, the open position limit is symmetric (that is, it applies to the sum of short and long positions), whereas in Argentina, Brazil, Korea, Malaysia, Peru, the Philippines, and Thailand, it is asymmetric (different limits are applied to short and long positions).

The assumption underlying the imposition of differential reserve requirements or ceilings on open positions according to the term of the position or the residency of the claimant is often that short-term claims and claims of nonresidents are more volatile than the long-term claims of residents, justifying stronger prudential measures. As an empirical matter, the accuracy of this assumption is not clear. Postmortems on several emerging market financial crises have suggested that domestic residents contributed importantly to the short-term capital outflows that occurred in the run-up to the crises in question.63

Some authors also question whether short-term capital flows are more volatile than long-term flows (see, for example, Dooley, 1996c). But even if short-term flows into the banking system are no more volatile than longer-term foreign investments on average, they have the greatest capacity to move out of the country in response to a sudden loss of confidence. Given the fragility of the banking system and its vulnerability to runs (especially given the limited capacity of the central bank to provide lender-of-last-resort support when it is simultaneously committed to defending the exchange rate), there is an argument for applying differential capital and reserve requirements and ceilings to short-term flows through the banking system as a form of insurance.

Since nondiscriminatory treatment of market participants is in general desirable, it is important to be clear as to why special measures toward banks might be contemplated. Banks are special in that their role as delegated monitors (on behalf of the holders of bank liabilities and equity) causes their balance sheets to be heavily loaded with claims on borrowers whose affairs are difficult for nonbank lenders to evaluate.64 That is, asymmetric information in the market for these claims can be relatively severe. Consequently, were banks forced to engage in distress sales of these assets, they could do so only at a significant loss. Combine this with the demandability of bank liabilities and the interdependence of individual banks (which are linked through, among other vehicles, the interbank market), and there is reason to think that a few important bank failures can cascade throughout the banking system, threatening the viability of the payments mechanism. This concatenation of risks is why governments and central banks provide a financial safety net to banks (and not, for example, to insurance companies and hedge funds). And given that banks enjoy the protection of a safety net, it follows that there is justification for targeting them with special prudential measures.65

The same type of argument provides the basis for special measures toward banks’ foreign currency exposures and short-term foreign currency exposures in particular. Given that the domestic lender of last resort cannot print the foreign currency needed to backstop the market when banks with net open foreign currency positions experience distress, such exposures may be a special source of systemic risk. There is then an argument for limiting them on grounds of systemic stability.66

The effectiveness of these measures in limiting the systemic risk associated with positions in foreign currency-denominated assets and liabilities has varied. Lack of transparency and inaccurate reporting of effective foreign asset positions (failure to report exposures associated with positions in derivative instruments, for example, and with positions in instruments containing explicit or implicit put or call options) can and sometimes have robbed these measures of their effects. Policymakers must avoid the tendency to think that they have solved the problem simply by putting measures on the books, without due vigilance to implementation (transparency and accuracy of reporting, in particular).

Leaving aside issues of transparency and accuracy of reporting, a problem with symmetrical open position limits (on the difference between banks’ foreign currency liabilities and assets) is that such regulations can give banks an inappropriate incentive to make foreign currency-denominated loans to onshore customers in order to match the currency denomination of their assets and liabilities.67 In addition, limiting the ability of banks to borrow abroad (by imposing position limits) or raising the cost of doing so (by applying differential reserve, capital, and liquidity requirements) may simply encourage nonbanks to do the borrowing for them. Corporates could borrow offshore in foreign currency and deposit the proceeds with domestic banks, which, their access to external funding restricted, would be inclined to offer relatively attractive deposit rates; the banks could then onlend the proceeds to their domestic customers. If corporates hedge their exposure by making foreign currency–denominated deposits, the banks will effectively end up with the same short-term foreign currency exposure as when there were no limits on their ability to fund themselves abroad. Assuming no change in the pressure on the authorities to provide the banks with guarantees, foreigners will have the same incentive to supply short-term foreign currency funding, because there will still be little question about their ability to get their money back. The vulnerabilities to which the financial system is subject will then be essentially unchanged.68

The logical implication of these issues is that proper prudential regulation of the banking system with respect to exposure to foreign currency risk needs to be concerned with total, direct and indirect, exposure to such risk. The question that must be addressed is, how would the banking system be affected in the event of a major (unanticipated) change in the exchange rate or an interruption of access to foreign currency credit, taking account of effects through the banks’ own balance sheet and off-balance sheet positions, as well as through the consequences for bank borrowers and even possibly for depositors and other creditors of banks. As the experiences in Mexico in 1995 (Goldstein and Turner, 1996), in Thailand in 1997 (Folkerts-Landau, 1997), and in Indonesia in 1998 amply demonstrate, banks can get into deep difficulties when their borrowers (in either domestic or foreign currency) are forced into insolvency or near insolvency by large foreign currency exposures in the face of massive depreciation of the domestic currency. Also, although this has not typically been a critical problem, the sudden withdrawal of foreign currency deposits to meet the foreign currency obligations of depositors in a crisis could put banks in difficulty unless they hold substantial and highly liquid foreign currency assets (with foreign currency claims against domestic borrowers not generally falling in this category). Prudential regulation and supervision of a banking system that effectively takes account of, and effectively controls, all of these direct and indirect channels of vulnerability is no easy task, especially when banks and nonbanks may not fully comprehend the risks to which they are exposed and may have strong incentives to evade prudential restraints in pursuit of perceived profit.

An alternative, or supplementary, approach to dealing with this prudential problem for some countries (especially where sound banking and bank regulation are not highly developed) might include broader efforts to discourage potentially destabilizing forms of capital flows through some form of tax or tax-equivalent measure applied generally to foreign currency borrowing (and other equivalent position taking). If it is intended to target short-term capital inflows on the grounds that these are a special source of systemic risk, the policy could be structured as a holding period tax—for example, like the Chilean measure, which requires that all nonequity foreign investment be accompanied by a one-year, non-interest-bearing deposit (whose tax equivalent therefore declines with the duration of the investment).69 Fischer (1998) and Mussa (1998) take this argument to its conclusion, suggesting that prudential regulation in the face of international financial liberalization should address threats not only to the stability of the banking system but also to financial stability created by the assumption of large volumes of short-term debt, particularly that denominated in foreign currency, not just by financial institutions but also by firms and the sovereign. Exposure to short-term foreign currency debt should be monitored because of the limited ability of debtors to avoid default on such obligations under adverse circumstances and because of the serious financial and economic disruptions that accompany such defaults. The high liquidity of short-term debt makes self-fulfilling debt runs a potential danger, and, unlike the situation with debt denominated in domestic currency, with debt denominated in foreign currency the central bank cannot backstop the market (because it is unable to print foreign exchange). As noted above, default by the sovereign, by much of the banking system, or by much of the business sector can destabilize the banking system and disrupt the economy. Hence, there may be a justification for extending the standard arguments for prudential supervision and regulation beyond the short-term foreign currency exposure of the banking system at least to the monitoring of other short-term flows, and perhaps to taxlike measures to discourage excessive exposure for the economy as a whole.

At the international level, there is also the issue of what might be done to lessen the risks of destabilizing international capital flows on the side of the suppliers of such flows. This issue is beyond the scope of this paper, but two suggestions are particularly relevant. First, the effort to improve data on flows of international credit from (and through) major international capital markets to emerging market countries should alert both lenders and borrowers to possible risks arising from excessive concentrations of debt, especially short-term debt. Second, consideration of whether risk weights applied to interbank lending by major international banks to emerging market counterparts accurately represent true economic risks might lead to more prudent behavior on the lenders’ side that will lessen the danger or extent of future international financial crises. In the end, it must be recognized that, as global financial integration inevitably deepens, an efficiently functioning international financial system will become ever more important to the welfare of all participants, and the adoption of measures that will lessen the risk and potential severity of financial crises will be in everyone’s interest. Moreover, long experience teaches that no financial system achieves perfection and that costly disruptions and occasional crises are, to some degree, unavoidable; it is therefore clear that serious attention must be given to the adequacy of international mechanisms for managing crises and containing their damage when they do occur.

Sequencing

The optimal sequencing of capital account liberalization is complicated. The essential caveat in any discussion of sequencing is that different countries’ situations vary greatly—in their levels of economic and financial development, in their existing institutional structures, in their legal systems and business practices, and in their capacity to manage change in a host of areas relevant for financial liberalization. Accordingly, there is no generally applicable cookbook recipe for the sequence of steps to undertake in financial and capital account liberalization, and there is no general guideline for how long the process should take. Presumably, a country with a fully liberalized domestic financial system that already had in place the safeguards necessary to ensure its successful operation could proceed almost immediately and with confidence to full capital account liberalization. However, this advice generally applies to countries (mainly the industrial countries) that already have quite liberal policies toward international capital. Maintaining tight restrictions on virtually all forms of international financial flows until the domestic financial system is fully and successfully liberalized is generally not an advisable strategy. Domestic and international liberalization can benefit from symbiotic interactions, but one needs to be careful about perverse interactions, particularly if opportunities made possible by international liberalization get ahead of relevant domestic preparations. Where domestic preparations are well advanced, essentially full international liberalization should be able to proceed relatively rapidly, say, within a decade or so for the more advanced emerging markets. Where the essential infrastructure for a liberal and stable financial system is not well developed, full liberalization, both domestic and international, will generally require more time if safety and ultimate success are to be reasonably ensured. Even with a gradual and prudent approach, there are likely to be bumps along the road. Bumps are not all bad. Learning to deal with them is one of the most important steps in building a liberal, open, and stable financial system.

With this caveat in mind, a few general principles can usefully be stated. First, the discussion in this paper has focused primarily on capital inflows and on the problems that arise when inflows are rapidly reversed in a crisis. Because banking systems play a central role in the financial affairs of most emerging market countries, liberalization of capital flows to and through the domestic banking system is already a significant reality in many of these countries. This is especially so for countries where domestic financial markets are little developed beyond the banking system and where there has been understandable enthusiasm to access the opportunities provided by world financial markets. Reversing this situation by going back to detailed restrictions on capital flows through domestic banks hardly seems sensible. Moreover, even for countries like China, where opening to direct foreign investment has preceded broad opening to flows through domestic banks, liberalization changes the environment in which banks operate at an early stage. Thus, in general, the most important point to recognize in sequencing reforms in conjunction with capital market liberalization is the danger of removing most restrictions on capital account transactions before major problems in the domestic financial system are addressed.

Among the problems that plausibly fall under this heading are inadequate accounting, auditing, and disclosure practices in the financial and corporate sectors, which weaken market discipline; implicit government guarantees, which encourage excessive, unsustainable capital inflows; and inadequate prudential supervision and regulation of domestic financial institutions and markets, which create scope for corruption, connected lending, and gambling for redemption. Countries in which these problems are severe, but that choose to suddenly and fully open the capital account nonetheless, run the risk of incurring a crisis. The implication is that countries should liberalize the capital account gradually, at the same time that they make progress in eliminating these distortions. Given the particular concerns associated with short-term foreign debt discussed above, there may also generally be a case for liberalizing longer-term flows, particularly foreign direct investment, ahead of short-term capital inflows.

Second, as a corollary, it is usually a mistake to liberalize the domestic banking system or to open it fully to international capital inflows if important segments of the system are insolvent (on an accurate accounting basis) or are likely to be pushed into insolvency by liberalization. As a general rule, it is desirable to weed out nonviable institutions and put remaining banks on a sound managerial and financial footing (and do the other things mentioned above) before liberalizing or opening the domestic banking system. When the domestic banking system is weak, opening it to competition from foreign banks, either through acquisition of domestic banks or startups of new institutions, is a delicate matter. Some reasonable amount of opening can provide valuable examples and help spread good banking practices and can also introduce useful competitive pressure for reform of domestic banks. Placing too much pressure suddenly on a weak domestic system, however, can provoke a crisis that, while it can sometimes speed reform, can also prove difficult to contain.

Third, while foreign direct investment sometimes raises concerns about foreign ownership and control, considerable evidence points to the economic benefits associated with such investment, including transfer of technology and of efficient business practices. Also, volatility in flows of direct investment does not appear to generate the same acute problems of financial crises associated with sharp reversals of debt flows. Thus, liberalization of inward direct investment should generally be an attractive component of a broader program of liberalization. Liberalization in this area need not occur all at once; for countries that face the prospect of large surges of inward investment, a gradual approach may be advisable. Also, from a macroeconomic perspective, it generally makes little difference if foreign investment is limited in some selected sectors of the economy for national security or other reasons. The financial sector, however, is an important exception.70 It may be argued that opening the domestic financial markets to participation by foreign (or multinational) financial institutions is an integral element of full capital market liberalization; and important benefits can accrue from diversifying risks, especially for smaller countries, which is made possible when banks can operate across national boundaries.

Fourth, with respect to liberalizing portfolio investments in domestic equities and debt instruments, there is the problem that the domestic markets for these assets and the necessary financial infrastructure for such markets (accounting practices, bankruptcy procedures, securities laws, and so on) are not well developed in many emerging market countries. This is especially true for corporate debt, mortgage instruments, and obligations of subsidiary governments or public investments (such as toll roads or water projects). Development of the relevant domestic markets and their essential infrastructure is necessary if these markets are to be opened internationally, although international opening can promote the development of domestic financial markets (particularly through the participation of experienced institutions). And, the economy can clearly benefit from the development of domestic financial markets that allow financial flows to be less heavily dependent on the banking system (Miller, 1998).

Fifth, concerning liberalization of capital outflows, international capital markets that provide wide opportunities for investors, risk hedgers, and speculators already exist and are comparatively easy to access once restrictions are removed (and often before restrictions are removed). The main concern with outflow liberalization arises when the restrictions to be removed are supporting either a significant macroeconomic disequilibrium or a highly distorted financial system. If an overvalued exchange rate has been maintained with the aid of outflow restrictions, then one must be prepared to adjust the exchange rate when restrictions are removed, with the black or gray market rate providing an indication of the degree of the required adjustment. Similarly, if financial repression has kept interest rates for savers artificially low, one must be prepared for a rise in rates when capital account restrictions supporting such repression are removed. Effects are likely to be felt in the government budget from debt-service costs and in the profits of enterprises and financial institutions that have been the beneficiaries of financial repression. Enterprises and institutions that looked solvent under the old regime may suddenly appear quite shaky. To avoid costly accidents, countries are advised to liberalize outflows after they have reduced macroeconomic disequilibria and financial distortions to manageable proportions.

58

Quirk and Evans (1995) emphasize the importance of adopting internationally accepted accounting principles and disclosure standards when capital movements are liberalized. As a positive example, they cite the efforts of the government of Argentina starting in 1992 to strengthen reporting, disclosure, and auditing requirements for banks. Conversely, Chile in the early 1980s is cited as an illustration of the special risks posed by inadequate auditing and accounting standards in developing countries with managed exchange rates. In such cases, interest rates are often well above interest rates on assets denominated in foreign currencies. (This may reflect a positive probability of devaluation or market segmentation together with a policy of sterilization of capital inflows.) Banks can make accounting profits so long as the currency peg is sustained by borrowing in foreign currency and lending in domestic currency. They may become insolvent if the peg collapses, but the government (which had ostensibly guaranteed the exchange rate to begin with) can be expected to come to the rescue. Akerlof and Romer (1993) argue that Chilean banks engaged in this type of behavior before the 1982 crisis. Dooley (1996a) describes this mechanism with reference to the Mexican crisis. He also notes that countries with a healthy fiscal position are more vulnerable to this type of crisis, because such a guarantee by the government may be more credible. Prudential limits on open foreign currency positions are designed to contain these risks, but they are not always successfully enforced, especially where banks can use offshore subsidiaries or derivative instruments to circumvent them. Garber (1996) documents how Mexican banks were able to circumvent prudential requirements on the eve of the 1994 crisis.

59

Including the liabilities of offshore and overseas branches of domestic banks to the extent that these imply potential claims on the domestic monetary authority.

60

Thus, capital requirements would be used to deter excessive risk taking (meaningful capital requirements implying that risktaking owner-managers have something to lose). Liquidity requirements would be used to discourage banks and other intermediaries from taking large positions in assets that could be sold only at a significant loss, undermining the solvency of the financial institution, in the event of a liquidity crisis.

61

To illustrate the underlying difficulties, consider Chile’s recent substantial reduction of their differential reserve requirement in view of a weakening capital account. Some might say that this calls into question the characterization of their measures as prudential, since one would not expect sound prudential measures to be particularly sensitive to variations in external capital flows. Others would respond that insofar as foreign borrowing, short-term foreign borrowing in particular, is a special source of systemic risk, it is precisely to variations in the level and availability of external capital flows that prudential measures should respond.

62

Johnston and others (1997), (Appendix Table 7) enumerates such measures for a sample of 17 countries.

63

Frankel and Schmukler (1996, 1997) have made the point that domestic markets moved before closed-end country funds in both the 1994–95 Mexican crisis and the 1997–98 Asian crisis, suggesting that domestic residents were first to move and international investors followed their lead.

64

On banks as delegated monitors and the connection of this concept to the notion of asymmetric information, see Box 1.

65

The distinction between banks and nonbank financial institutions in terms of prudential policy could be further nuanced to allow for the fact that, nationally as well as internationally, increasing attention is being paid to the systemic implications of activities undertaken by securities and insurance firms, especially when they are part of a financial conglomerate.

66

Such measures can be thought of as nondiscriminatory because the country in whose currency the claim is denominated is not ultimately the basis for the differential treatment, but rather the implications of the attributes of that claim for systemic stability.

67

One might well ask why banks choose to hold domestic rather than foreign investments in order to close their open positions. One possible answer is that there exist other distortions affecting interest rates and exchange rates that provide an incentive for domestic rather than foreign investment. But the asymmetric information perspective suggests that domestic banks have a comparative advantage in acting as delegated monitors of domestic customers.

68

If, however, corporations made domestic currency deposits, they would assume the foreign exchange exposure and be subject to similar insolvency risk from exchange rate changes as the banks in the scenario that involves no restrictions. It seems likely that the authorities that had previously felt impelled to extend guarantees to the banks would now extend similar support to nonbanks, having induced the latter to take on financial intermediation responsibilities.

69

Given the prominence of the Chilean case in recent discussions of policy toward international capital flows, the country’s experience is considered in some detail in Appendix IV.

70

Although liberalization of trade in financial services is treated as a trade policy issue under the auspices of the World Trade Organization (see Dobson and Jacquet, 1998, for an analytical appraisal), it is one with potentially important macroeconomic implications that need to be clearly recognized.

Cited By

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