What are the market infrastructure and regulatory frameworks needed to reap the benefits—and contain the risks—of financial integration? What are the next steps for institutional reform and development in Asia?


What are the market infrastructure and regulatory frameworks needed to reap the benefits—and contain the risks—of financial integration? What are the next steps for institutional reform and development in Asia?

II. Role of Institutions and Markets to Foster Financial Integration and Economic Stability12

A. Introduction

What are the market infrastructure and regulatory frameworks needed to reap the benefits—and contain the risks—of financial integration? What are the next steps for institutional reform and development in Asia?

There are well-known benefits from increasing financial integration in Asia. Benefits include greater competition and efficiency of financial institutions, product innovation, lower cost of capital, longer maturity of financing, greater diversification of risks, greater liquidity in traded securities, increased transparency, more sophisticated risk management, and improved trading and settlement practices. Overall, financial integration can help a country develop its financial sector, making resource allocation more efficient and the economy more resilient to shocks. At the same time, financial integration carries risks that must be anticipated and managed. Foremost is the greater volatility of capital flows, which may result in sharp changes in interest and exchange rates that have negative consequences for the real economy. Financial product innovation and increasing liberalization may reduce costs and risks but can also expose investors to new risks. There are also potential risks from increasing cross-border linkages, through abrupt changes in capital flows or contagion. These risks raise important issues regarding the sequencing of liberalization, and balancing the risks and benefits of integration.

In the first seminar held last September, the consensus was that Asian financial integration had lagged intraregional trade integration. Liquid and well-regulated capital markets were viewed as essential for the effective allocation of the region’s savings and to strengthen the region’s resilience to domestic and external shocks. Future steps to encourage financial integration should include the development of financial market infrastructures, such as clearing and settlement systems and credit-rating agencies, as well as the harmonization of financial regulatory and supervisory standards in line with international norms and best practices. This would set the stage for greater cross-border flows of capital and financial services.

What are the key reforms needed to promote greater financial integration in Asia? Financial services are conditioned by a host of factors—affecting demand and supply—such as cost and availability of funds, transparency, well-developed infrastructures, prudential regulation, and market openness. This paper provides background information on key reforms in these areas that would facilitate greater financial integration in Asia. These reforms are designed to (i) strengthen capital markets so as to increase investor sophistication and improve the investment climate; (ii) build regional infrastructures to facilitate trading; (iii) minimize risks associated with greater integration; (iv) remove impediments to cross-border activities; and (v) harmonize rules and practices across the region, as well as with global norms and best practices, to instill confidence (Figure II.1). Obviously, reforms must recognize the diverse state of development of Asian economies and should be adapted and sequenced to country-specific circumstances. These reforms are also interlinked. For example, steps to build strong market infrastructures among economies to encourage regional trading and investment will not be effective if there are regulatory impediments that discourage cross-border activities.

Figure II.1.
Figure II.1.

Key Reforms to Foster Integration

Citation: IMF Working Papers 2006, 196; 10.5089/9781451864564.001.A002

These key areas for reforms are well-recognized and Asian policymakers have already started many initiatives to address challenges in these key areas. These include steps to create regional Asian financial markets, such as the Asian Bond Market Initiative, the Asian Bond Fund (ABF), increased links between stock exchanges, and the Association of Southeast Asian Nations (ASEAN) Finance Roadmap; to collaborate in adopting global standards and best practices; and to establish regional mechanisms for crisis management and prevention.

Nevertheless, further reforms could foster well-functioning financial systems and lay the groundwork for greater integration. In Section B, we discuss reforms to strengthen capital markets while Section C touches on needed improvements to domestic and regional market infrastructures. As financial integration carries risks that must be anticipated and managed, Section D focuses on the appropriate steps to deal with such risks. Section E identifies some remaining barriers to cross-border flows and transactions and considers issues pertaining to further liberalization. Section F then discusses the task ahead in harmonizing rules and practices, including supervisory and regulatory frameworks. Section G explores regional and international mechanisms to foster integration and manage attendant risks as key areas for reforms—both domestic and regional—can benefit from regional and international cooperation. Section H concludes.

B. Strengthening Capital Markets

The integration of Asian financial markets with the global financial system is well advanced. By contrast, intraregional financial investments are surprisingly low (Appendix II.1). Many Asian countries have therefore recycled their savings elsewhere. At the same time, domestic firms continue to depend excessively on bank intermediation. The reasons for stronger financial linkages are wellknown—better risk sharing, more efficient allocation of capital, more productive investments, and ultimately more resilient economies. Asian policymakers have recognized the importance of strengthening capital markets, and many initiatives have been launched, at the national and regional level’s to deepen domestic markets and establish pan-Asian markets. What more can be done? Here we focus on three areas for further reforms: (i) developing institutional investors, especially pension funds; (ii) strengthening corporate governance; and (iii) improving the transparency and consistency of financial statements.

Developing institutional investors

Reforms aimed at strengthening the investor base by increasing the role of institutional investors—asset managers, insurance companies, and pension funds—can have a profound impact on the development of regional capital markets. Apart from macroeconomic stability which fosters long-term financial savings, the impact of institutional investors in broadening and deepening capital markets could be strengthened by the appropriate tax treatment for long-term saving products, the transparency of such financial products, the ability of foreign institutions to enter domestic markets, and a level playing field vis-à-vis banks in competition for household savings. Rules on permissible products and investment guidelines—especially for equity or foreign securities—may also need to evolve over time and thereby facilitate the development of regional markets and new financial instruments.

Pension reforms are a key measure. Historically, pension funds in Asia have been state-sponsored and defined benefit. These pension funds have generally invested in domestic instruments issued by governments. Reforms could include liberalization to allow for a move away from state-sponsored plans, greater choice between defined benefit or contribution schemes, and changes in regulations to allow pension funds to better manage their risks.

Table II.1.

Pension Fund Portfolio Allocation

(as a percent of total)

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Sources: Australian Bureau of Statistics, BOJ, IMF, Malaysia EPF, MPFA, New Zealand’s Superannuation Fund, OECD, Thailand Government Pension Fund, and IMF staff calculations.Notes: Coverage is not complete in all countries. Figures are as of 2005 for Australia, Hong Kong SAR, Japan and New Zealand, 2004 for Indonesia, the Republic of Korea, Malaysia, Singapore, and Thailand, and 2001 for the United Kingdom and the United States.

Many Asian countries are increasingly promoting private pension provision and this trend is to be encouraged. As populations age across the region, publicly provided defined benefit pensions have become increasingly costly. A multi-pillared pension system can help relieve the burden and allow for more flexibility. Encouraging the development of privately funded pensions can also increase the flow of long-term institutional savings and boost the overall development of the financial market. At the same time, greater risk-taking on the part of individuals—especially if defined contribution schemes were to become widespread—would require stronger consumer protection and increased financial literacy.

Strengthening corporate governance

Strengthened corporate governance is essential for deep and liquid financial markets. As investors are ever more demanding and discriminating, strong corporate governance creates an attractive investment climate. Corporate governance in Asia has generally improved since 2000. However, the prevalence of controlling holdings of companies by families or other corporations continues to place importance on the protection of minority shareholders. Such protection includes facilitating proxy voting, pre-emptive rights for existing shareholders to participate in capital increases, and mandatory disclosure of underlying and interlocking shareholdings. There is also a need for cost effective legal channels for shareholders seeking redress to ensure that rights can be practically enforced. Takeover codes are an important element to ensure a fair market for corporate control and examples such as the Hong Kong, SAR and Singapore Codes on Takeovers and Mergers provide a useful model to follow. The increasing number of countries that have received corporate governance assessments as part of the ROSC program is encouraging and policy recommendations from these assessments should be pursued.

Table II.2.

Corporate Governance Ratings, 2000-2004

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Source: Asian Corporate Governance Association.Note: Based on an analysis of more than 400 companies. Questions were on all aspects of corporate governance, each rated between 0 and 100 and then averaged for the whole country.

The role of the Board of Directors in protecting shareholder rights is fundamental and more training and guidance for this role is needed. One option is to establish training programs for Directors to provide them with a better appreciation of their role and responsibilities, as in the case for Thailand which has been running a Directors Certification Program since 1999. In addition, the establishment of board committees for listed companies can improve accountability. Many Asian countries require companies to have an audit committee but do not similarly require remuneration or nomination committees. Making sure boards have a minimum number of independent directors is also important. Finally, insider trading regulations need to be strengthened and rigorously enforced in a number of countries and related party transactions need to be made more transparent.

Corporate governance standards in the banking sector require special attention, given the dominant role banks play in regional finance. Shortcomings in the governance of banks not only lowers returns to shareholders, but can also destabilize the financial system. Particular attention needs to focus on family-owned banks to ensure that related-party lending between the bank and its owner family (or associated companies) occurs in a manner consistent with sound banking practices, and on state-owned commercial banks to avoid state interference in these banks’ commercial activities. These issues are explored extensively in the Asian Roundtable Task Force on Corporate Governance of Banks in Asia and the recommendation to develop independent rating mechanisms for the governance of banks deserves consideration.

Improving transparency

Increased transparency and accountability through moving to a common financial reporting framework—the International Financial Reporting Standards (IFRS)—is another key reform. This will not only facilitate the access of domestic companies to international capital markets but it will also provide foreign investors more efficient access to domestic markets. Further, a common accounting standards framework can reduce the costs for maintaining multiple accounting frameworks for companies that operate in or obtain financing from different jurisdictions. To ensure the consistent application of IFRS, external audit of financial statements should preferably be based on the International Standards on Auditing. A regional or national supervisory body that ensures the quality and consistency of the auditors’ work (similar to the Public Company Accounting Oversight Board created by the Sarbanes-Oxley Act of 2002) could increase public confidence in the transparency and quality of the financial statements.

C. Building Market Infrastructures

In addition to more sophisticated investors, stronger corporate governance, and greater transparency, well-developed market infrastructures—domestically and regionally—can help foster regional financial integration. Well-functioning capital markets, especially government bond markets, facilitate financial intermediation and risk management; regional linkages facilitate cross-border capital flows. Again, this is an area where Asian policy-makers have started many initiatives in the last few years. In many Asian countries, market infrastructures have been developed nationally but, apart from a few exceptions, regional systems and linkages are rudimentary. The remaining agenda includes steps to: (i) enhance the depth and liquidity of capital markets, especially bond markets; (ii) establish links between national clearing and payments systems; and (iii) create regional credit rating agencies and benchmarks.

Enhancing market depth and liquidity

Further steps to improve transparency, encourage diverse participants, and develop derivative markets could enhance depth and liquidity in capital markets. For instance, bond markets have been developing rapidly since the 1997 crisis, supported by domestic and regional initiatives. Nevertheless, while the primary issuance market works well, there is poor liquidity in most secondary markets. A number of steps could be taken to address this.

  • First, measures could be taken to enhance transparency to promote market participation, and hence market liquidity. For example, disclosure of information about the general issuance strategy could help market participants to formulate their investment strategies. Also, trade information in the secondary market should be promptly disclosed to the public, with due attention to ensuring anonymity of market participants. For instance, OTC trades in fixed income securities should be reported on a prompt basis to a central system (such as the BIDS system used in Malaysia). For illiquid assets, it is important that bond pricing agencies exist to provide independent valuations for portfolios. Korea has established bond pricing companies to provide such a service. A related issue is pricing of credit risk. Standards for rating requirements may need to be strengthened to ensure consistency.

  • Second, diverse participants could be encouraged to participate. Different market participants with a variety of transaction needs and investment horizons would promote liquidity. On example are the reforms to develop institutional investors discussed earlier.

  • Third, related markets and facilities such as futures, swaps, repos, and securities lending enable different investors to construct their investment portfolios and risk management strategies, hence increasing liquidity and trading activities. A recent example has been the development of securities lending through a web-based custodian service (ISCAP) in Malaysia.

  • Fourth, changes to prudential regulations or accounting conventions that might hinder trading. Examples include high statutory liquid asset requirements or accounting regulations that require financial institutions to value their portfolios at lower of cost or market value. These requirements may inadvertently discourage secondary trading.

Figure II.2.
Figure II.2.

Government Bonds Annual Turnover Ratios in 2005

Citation: IMF Working Papers 2006, 196; 10.5089/9781451864564.001.A002

Source: Asia bond monitor, Bond Marke Association of USA.Note: US figure is for 2004.

Linking clearing and settlement systems

Clearing and settlement processes are well-developed in many Asian markets, so attention could focus on establishing regional linkages. Previous studies show that most markets in Asia have fairly advanced clearing and settlement processes and are increasingly adopting Delivery versus Payment (DVP) systems. In addition, the development of supra-national clearing and settlement systems would improve the liquidity of regional bond markets and help attract more regional investors (Box II.1). Bilateral links between national Central Securities Depositories (CSD) have not taken off in the region but rising levels of cross-border trading will increase the need for efficient and safe infrastructure platforms. There has been much discussion in the past on the possibility of creating an International CSD for Asia (AsiaClear), though thought could also be given to working with existing ICSD’s such as Euroclear to develop a cost-efficient global service without needless infrastructure replication. Many countries have used Euroclear for their debt issuance to increase the ease of investment for non-residents. Obviously, steps to develop regional links should be driven by a viable commercial case.

Clearing and Settlement Systems Linkages Between Selected Asian Countries

Many Asian economies’ settlement systems are linked with the international CSDs. This is more to enable international market participants to trade and settle local government bonds than to facilitate local market participants trading and settling international bonds. However, there are currently only very few links within the region and those that do exist are infrequently used.

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Source: ADB

Regional credit rating and benchmarks

The development of a regional risk rating agency should also be facilitated, as a means of ensuring standardized ratings and a more complete coverage. Most countries in the region have well-developed ratings agencies, many affiliated with the major international agencies (Moody’s, S&P, and Fitch) (Box II.2). The standards being used by these agencies are similar and it should be reasonably straightforward to adopt unified rating standards across the region. The convergence of current national rating agencies into stronger regional rating agencies may also be beneficial in terms of economies of scale and standardization. This may lead to greater coverage by rating agencies of small and medium sized companies that have issued securities.

Cooperation among Credit Rating Agencies in Asia

While there are some 30 domestic credit rating agencies operating in Asia, a survey of international and domestic investors conducted by the Asian Bankers Association (ABA) suggests that they are still in their development stage as regard to (i) timeliness of rating actions; (ii) accuracy and quality of reports and analysis; and (iii) credibility.

In order to address these issues, the Association of Credit Rating Agencies in Asia (ACRAA) was organized in September 2001. Currently, it has 22 credit agencies as members from 12 economies in the region including: Bangladesh, China, India, Indonesia, Japan, the Republic of Korea, Malaysia, Pakistan, the Philippines, and Thailand. Its objective is to exchange information, experiences, and skills among credit rating agencies in Asia to enhance their role in providing reliable market information. It also aims to undertake activities to promote (i) the adoption of best practices and common standards that ensure high quality and comparability of credit ratings; and (ii) the development of capital markets in Asia and cross-border investment throughout the region.

D. Minimizing Risks

Greater financial integration brings about risks that have to be anticipated and managed, especially as institutions and individual invest in new markets and instruments. Aside from the potential for currency mismatches and risks arising from country exposures, risks also arise from institutions that are increasingly active in a variety of financial sectors and geographical regions. How should such risks be managed? A strong framework for prudential regulation and supervision is necessary to ensure that risks arising from integration are being assessed and managed well. At a minimum, this involves a move towards risk-based supervision, and changes in prudential regulation and supervisory oversight to address cross-sectoral and cross-border activities.

Moving towards risk-based supervision

National authorities in Asia have made commendable progress in introducing risk-based supervision, although effective implementation will take time. Supervisors recognize that they have to go beyond a compliance or “checklist” based approach in supervision to one that requires a thorough understanding of an institution’s activities and its risks. Most supervisors in Asia have made progress in issuing guidelines and procedures for assessment of different risks and in developing the required databases. However, the capacity to understand risk and effectively supervise institutions will take time and experience to develop. For banking, moving towards risk-based supervision is also key for effective implementation of the Basel II framework.

Risk-based supervision is necessary to effectively manage risks from new investors and more sophisticated financial products. These investors and instruments—such as hedge funds and securitized instruments—have brought much benefit by broadening the investor base and providing more avenues to raise capital as well as to manage risks. At the same time, the combination of low risk premiums and untested elements of risk management, especially in an environment where markets are still developing, continue to be concerns. Of course, this is not just a concern in Asia but also for the global financial system. Regulators and supervisors need to be mindful of these risks.

In banking, Basel II provides a more risk-sensitive prudential and supervisory framework even if several issues have to be considered during implementation. Many Asian countries have indicated that they will adopt the Basel II framework (Appendix II). This raises several issues including (i) capacity to supervise banks on a risk-based approach, (ii) home-host information sharing and coordination, and (iii) competitive inequalities and the need to upgrade domestic banks. Cross-border cooperation is essential in implementing Basel II as some supervisors in Asia may implement the advanced approaches later than the home supervisors (or vice versa). In addition, cooperation between home and host supervisors is necessary to ensure different capital requirements do not lead to regulatory arbitrage or unexpected risk migration. For authorities, it is important that meeting self-imposed deadlines for implementation does not take precedence over the quality of the implementation.

Addressing cross-sectoral and cross-border issues

Consolidated supervision—and close cooperation among sector supervisors—is needed to deal with risks from diversified financial groups. Financial groups are susceptible to contagion as problems can be transmitted within the group through intra-group transactions and reputation effects. In many developing Asian countries, supervisors are still in their early stages of implementing consolidated supervision, both on a domestic and a global basis. Furthermore, as found in many BCP assessments, co-operation among supervisors in the different sectors needs to be improved.

Table II.3.

Examples of Local Financial Conglomerates in Selected Asian Countries

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Source: Banks’ website.

With deeper cross-border linkages, improved cross-border supervision and cooperation is also increasingly important. Both home and host supervisors will need to work together to ensure effective oversight. Efficient cooperation and information sharing requires that each supervisor is equipped with strong risk assessment capability, clear prudential regulations, and ability to take remedial measures. Cooperation between supervisors is especially important when dealing with problems or issues faced by regionally or globally active financial institutions. This would include information sharing, global monitoring of risks, as well as coordinating remedial actions or crisis management, including lender of last resort arrangements. These considerations may become complicated as some institutions become “too-big-to-fail”—in one or many jurisdictions. At a minimum, home and host supervisors need to have in place memorandum of understandings (MOUs) that sets out agreements on these issues so as to underpin effective supervision and crisis management.

Table II.4

Major Financial Groups with Cross-Border Presence in Selected Asian economies 1/

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Sources: Fitch Reports, and banks’ websites.

Countries and region surveyed include China, Hong Kong SAR, India, Indonesia, Japan, the Republic of Korea, Malaysia, the Philippines, Singapore, and Thailand. Banks owned by nonfinancial groups are not included.

Size of banks is in terms of total assets.

E. Removing Impediments

The removal of capital and exchange controls could increase cross-border flows and competition. This would enable investors and firms to tap regional markets to find the lowest cost of funding and highest risk-adjusted return. Capital controls in Asia have been gradually liberalized and, in general, no longer stand in the way of cross-border investments in many countries. However, rules in some countries still inhibit cross-border flows while in others, limits on the level of ownership and associated rights still remain (Appendix III). In many countries, the existing prudential requirements biases investment toward domestic assets.

Further capital account liberalization

While capital accounts in many Asian countries have been gradually liberalized, further steps could be taken to relax restrictions on cross-border investments while maintaining appropriate prudential safeguards. Asian countries have made significant progress in opening capital accounts in the past decade and regulations limiting residents from investing or raising funds abroad have been incrementally relaxed. However, there are wide differences across the region. For instance, Australia, Japan, Hong Kong, SAR, New Zealand, and Singapore, have the most open markets with limited restrictions on cross-border investment and by and large these relate to non-economic considerations. Korea and Thailand have also increasingly opened their markets to cross-border investment, especially in the aftermath of the Asian crisis; Malaysia has also relaxed all the emergency measures taken to control cross border investments. In other Asian countries, however, various restrictions remain, particularly on resident investments abroad and on the ability of foreign investors to buy in local stock markets. For instance, in China, portfolio inflows are controlled, and only Qualified Foreign Institutional Investors are allowed to invest in A-shares and stock exchange-traded debt securities in domestic markets and in India, inflows by foreign investors are limited. However, in both countries, restrictions on overseas investments by large institutions including pension funds are being slowly relaxed. Obviously, further liberalization has to be sequenced appropriately and conditioned on a well-functioning and well-regulated domestic financial system.

Liberalization of financial services and prudential regulation

There may be a need for countries in the region to prepare for further liberalization of the financial services sector, especially in terms of commercial presence. Based on the General Agreement on Trade in Services (GATS) commitments in 1997, Asian countries made the least commitments to opening up their core banking services and the second lowest commitments after Latin America to open direct insurance services.13 Currently, most Asian countries have market access rules for commercial presence that go beyond their commitments in the GATS. However, in many cases, controls and limits remain on ownership share, voting rights, licenses, and branch networks.

Further liberalizing the financial services sector would be beneficial. This applies only to the WTO process, but also to unilateral liberalization or bilateral agreements. Within the WTO process, the WTO Ministerial Declaration in Hong Kong SAR shows a commitment to intensify and expedite the negotiations on trade in services in all modes (Box II.3). Outside the WTO, liberalization of financial services through regional agreements such as ASEAN has not been effective, while a few Asian countries such as Singapore have chosen to open up their financial services sector through bilateral trade agreements.

Another reform is to reexamine prudential limits on pension funds’ and life insurers’ investments. Most Asian countries have placed quantitative limits on contractual savers’ investments as opposed to “prudent man” rules.14 There is no pressing reason to change this approach if regulations avoid minimum investment limits and allow adequate diversification. However, in many Asian countries, fund assets are invested entirely domestically, and predominantly in government bonds. Thus, even domestic asset diversification has been limited as a result of regulation. As assets under management increase over time as a result of both demographic change and greater coverage, these limits may become more difficult to maintain. In many instances, regulatory limits can interact with a lack of supply of high-quality domestic assets to produce very distorted portfolio holdings. In addition, savers will benefit if portfolios are more optimal in terms of asset and country allocation. Of course, the relaxation of quantitative limits needs to be conditioned on ensuring robust risk management practices within the fund management and under the appropriate regulatory and supervisory framework.

Liberalization of Financial Services under the Doha Round Negotiations

The first round of multilateral negotiations on financial services in the context of the GATS was concluded in December 1997, and came into effect in March 1999. Under the Doha Round Negotiations, started in 2001, WTO members agreed on an agenda for comprehensive multilateral trade negotiations that incorporated trade in services.

Asian countries generally agree that liberalization has a long-term benefit but have also called for prudent supervision to protect consumers and manage associated risks. Liberalization must take into account the level of developments of financial markets and the capacity of related institutions. In the latest request, a group of developed countries and a few emerging market countries (including the United States, the European Union, Australia, Canada, Japan, the Republic of Korea, and Hong Kong SAR) have proposed the removal of discrimination between domestic and foreign suppliers regarding application of laws and regulations (national treatment). They are also keen on higher level of commitments on commercial presence, and believe that technological advance calls for a move towards more commitments for cross-border trade especially for some sub-sectors such as financial information and advisory services, reinsurance and retrocession, MAT insurance and services auxiliary to provision of insurance. Their request directly targets many emerging market countries in Asia including China, India, and all ASEAN countries.

F. Harmonizing Rules and Practices

An unfinished agenda is to address differences in laws, regulations, and tax treatments that still prevent investors—from both within and outside Asia—from building pan-regional portfolios. This is a difficult and painstaking task, requiring close collaboration among countries and assistance from relevant international institutions and agencies, but it has the potential to produce large payoffs. Where global standards and best practices exist, there are strong benefits from harmonization that is consistent with those standards and practices. Harmonization is particularly crucial in the regulatory and supervisory frameworks for insurance, pension, and securities markets (all crucial for capital market development) as well as banks. Together with efforts to address weaknesses in market integrity, implementation of global standards and best practices is a necessary step to mitigate risks arising from more financial integration; it also serves to instill investor confidence. At the same time, more equal treatment of taxation across the region could facilitate cross-border trading.

Strengthening implementation of global standards and best practices

Within regulatory and supervisory frameworks, nonbank financial institutions and capital markets deserve emphasis. These are key if institutional investors—insurance companies and pension funds—and capital markets are to become more integrated.15 Key challenges are:

  • In insurance, the establishment of full-fledged regulatory and supervisory regimes. There is a need to strengthen solvency regulation and supervision, which then has to be complemented with sound corporate governance and effective risk management.

  • The improved regulation and supervision of provident and pension funds. This would benefit members and increase the transparency of these institutions. While banks and insurance companies in Asia generally operate subject to a regulatory framework, there has, with a few exceptions, been an absence of a regulatory body for provident and pension funds. As these funds are often monopoly providers, there tends to be little competition for customers, giving the importance of robust regulation an added significance. The Mandatory Provident Fund Schemes Authority (MPFA) of Hong Kong provides an example of one possible approach, while India has a bill before parliament to approve the creation of a new regulatory body for pension funds.

  • Effective supervision of the contractual savings sector—asset managers, life insurers and pension funds. As the sector is liberalized, supervision will be increasingly important. Proper risk management is crucial to the stability of these institutions if asset requirements are liberalized and investment is based on prudent man rules. At the same time, the move towards investment-linked products and defined contribution private pension schemes shifts investment risks to individuals and should therefore be underpinned by effective disclosure regimes and professional market conduct.

  • For capital markets, strengthening the supervisor’s independence, powers to enforce the rules, and capacity to conduct adequate surveillance. Independence and enforcement are not unique to Asia; these are the main challenges faced by capital market regulators globally. In addition, securities supervisors in Asia need to improve information sharing with other sector supervisors both within the country and abroad.

In addition, weaknesses in the prudential and supervisory framework for banking still need to be addressed. In general, weaker areas include those relating to prudential regulation and requirements, on- and off-site supervision, and provisions for information sharing between supervisors. Further, the BCP assessments suggest that developing Asia lags behind in the principles that are deemed most crucial to adopting Basel II. These include capital adequacy, loan evaluation and loan loss provisioning, risk management systems, consolidated supervision, accounting standards and remedial measures.

Many parts of Asia are considered to be vulnerable to money laundering and terrorist financing activities due to weak AML/CFT regimes and the widespread use of the informal sector to move funds. There are potential reputation risks to individual countries if their frameworks are not improved, such as the curtailment of correspondent banking relationships. The priorities are to implement the key financial sector preventative measures, conduct supervisory oversight of compliance, and undergo assessment of frameworks.

Consideration could be given to reviewing taxes on capital market transactions and the possible benefits of more harmonization across the region. Such taxes may come in the form of transaction taxes and stamp duties; taxes on dividends and capital gains; and withholding tax. Transaction taxes tend to introduce inefficiencies and distortions; taxes on dividends and capital gains could carry an element of double taxation, and withholding taxes can introduce disparate treatment of different taxpayers. The differences in tax regimes across the region, and differences in treatment of residents versus non-residents hinder the development of regional capital markets as they prevent free movement of capital across the region. These problems are fairly universal, and typically dealt with bilateral tax treaties (as with the G-7 countries) that try to balance the revenue and capital market development considerations. A more pro-active regional approach to identifying tax-related problems, and policies toward a more harmonized approach to capital markets taxation would be advantageous.

Regional efforts at harmonization

Regional efforts at harmonization will be most useful if they are based on globally accepted practices. There is an on-going discussion whether Asia needs its own standard which is different from global standards. It would seem wise to emphasize convergence with globally accepted standards and best practices. For one, this would facilitate easier global integration. In addition, it would also minimize efforts required to create regional standards and best practices.

However, there is scope for flexibility when aligning domestic rules and regulations with global standards. Given the substantial diversity in size and degree of maturity in Asian financial systems, some countries in the region may not be ready to embrace immediate harmonization with global standards and best practices in a given field, but may be able to take concrete steps toward an identified common objective. The more flexible model of cooperation, therefore, seems best suited to the region.

The example of “open coordination” within the EU process for financial coordination may be useful for Asia. Financial cooperation in Europe was based on an “open coordination” model that uses emulation for the spread of best practice and relies on trust and self-control, rather than on legally binding commitments. Under this model, countries work together voluntarily to define common objectives, set regional guidelines combined with specific timetables for meeting objectives, establish qualitative and quantitative benchmarks against best practice, and translate regional guidelines into national policies by adopting specific policies tailored to national circumstances (Box II.4). Of course, harmonization in Europe occurred in the context of greater political and monetary integration, and with possibly lesser differences among member’s financial sectors.

EU’s Experience with the Financial Services Action Plan

The EU commission initiated the 5-year Financial Services Action Plan in May 1999 to create a single market for financial services in the EU. Underlying the plan was the recognition that financial services were increasingly becoming an international market and that any European rule would have to be compatible with those used globally.

The distinctive feature of the plan was that the rules were to be tight and restrictive enough to ensure legal certainty and confidence, but also loose and malleable enough to allow institutions to act and adjust on an international level. It comprised 42 measures to harmonize the member states’ rules on securities, banking, insurance, mortgages, pensions, and all other forms of financial transactions.

By its 2004 deadline, 39 of 42 measures were adopted. Among the 21 directives contained in the action plan, the average timeframe for adoption by the European parliament and council was just short of 22 months, which was a significant success for a program of this scale. The plan has been successful not only in harmonizing rules for the financial sector but also in fostering an atmosphere of cooperation between the European institutions and market participants.

For Asia, the main lesson is that harmonization can take place in a de-centralized manner. One way to begin is by conducting diagnostic assessments in each country against global standards and best practices to identify existing gaps. This could be followed by agreement on regional guidelines for practices and rules with which countries could gradually align themselves. The other option for Asia is to adopt a more centralized approach: however, such an approach would require strong political will and consensus.

Some promising advances have already been made through bilateral arrangements or subcommittees and working groups of international and regional fora. For instance, the EMEAP WG on Payments and Settlement Systems has compiled payment and settlement systems assessments in member countries. The OECD/World Bank Corporate Governance Roundtable in Asia continues to provide an avenue to promote a regional framework based on global best practice.

G. Improving International and Regional Cooperation

Asian countries have made commendable achievements in post-crisis initiatives in financial cooperation including enhanced information exchange and policy dialogue, bilateral reserve sharing, and regional capital market development (Appendix V). Promising efforts involve the ASEAN+3 Economic Review and Policy Dialogue Process and information gathering through the ADB Asia Regional Information Center (ARIC), EMEAP, as well as Chiang Mai Initiative and Asian Bond Fund Initiative. Further, ASEAN+3 countries have recently announced their possible move toward “multilateralization” of the current bilateral swap arrangement under the Chiang Mai Initiative by pooling their reserves, to address its inherent shortcomings of funding uncertainty and inefficiency.

Further areas for cooperation could include the following:

  • Work to establish regional infrastructures such as clearing and payment systems, credit rating agencies, and benchmarks. This would complement ongoing initiatives such as the ASEAN Financial Roadmap and work in EMEAP.

  • Efforts to harmonize rules and practices across the region and with global standards and best practices. In this regard, FSAPs and ROSCs could be useful instruments to benchmark Asian countries against best practices and identify priorities for reform. Further, as in the case of Central America, the Euro area, and the Nordic region, the IMF, together with the World Bank where appropriate, has worked with the respective regions to address cross-border regional issues in financial sectors (Appendix VI).

  • Cooperation among supervisors at the regional level to complement bilateral relationships. Aside from bilateral meetings and agreements, it may be useful for regulators and supervisors to discuss developments in a regional forum. This may be necessary to identify cross-cutting issues such as concentration risks, large exposures, or risky activities that may not be evident to any one supervisor. This is not unlike the role played by the Financial Stability Forum (FSF) on a more global level.

  • Coordination in crisis management. As institutions become active in a number of jurisdictions, crisis management becomes more complicated. Without touching on more intensive, and politically sensitive issues such as solvency support, much could still be done at the technical level to coordinate crisis management and contingency plans. This could involve protocols to share information and resolve practical issues such as public communication, and payments and settlements.

H. Concluding Remarks

Steps to further develop domestic and regional markets, improve oversight, and strengthen mechanisms for financial sector cooperation and coordination would foster a more integrated Asian financial system. While well known, reforms in these areas require difficult and painstaking work, and will take time to implement and become effective. However, they have the potential to produce large payoffs. The objective of these reforms is to foster healthy institutions and markets that are able to assess and manage risks well. Asian countries will then be able to reap the benefits from more integrated and globalized financial systems while minimizing risks.


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Appendix II.1. Key Financial Market Indicators

Size of Financial Markets (Amount Outstanding) in 2004

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Source: IMF, World Federation of Exchanges; Dealogic Bondware; national authorities; BIS

Domestic and international bonds and notes in domestic currency issued by residents and non-residents.

Inter- and Intra-regional portfolio investments in 2003

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Source: Asia Bond Monitor.

AUM of Institutional Investors in Asia, End of 2004

(in percent of GDP)

Citation: IMF Working Papers 2006, 196; 10.5089/9781451864564.001.A002

Sources: IMF staff calculations based on IFS, Investment Company Institute, and national authorities.

Appendix II.2. Regulations on Cross-Border Portfolio Investments in Selected Asian Countries

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Source: IMF, Asian Bonds Online.

Appendix II.3. Implementing Basel II: Asias Intentions

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Source: IMF staff.

Appendix II.4. Regional Compliance with Standards and Codes

This appendix reviews the reports on the observance of standards and codes (ROSCs) in the areas related to financial sector in Asia. The information used here is from the assessments done both independently by the IMF/WB team and through the Financial Sector Assessment Programs (FSAPs) between 1999–2005. The peer group for developed16 Asia is OECD countries while the peer group for developing Asia is middle-income countries. The analysis here should be read cautiously since some assessment are dated and coverage is not complete.

Basel Core Principles (BCPs)

Developed Asia in general achieved about 85 percent compliance with the BCP, compared to OECD average of 90 percent. BCP assessments identified some weaknesses mainly in the arrangements for sharing information between supervisors, country risk monitoring and control, anti-money laundering practice, and effective on-site and off-site supervision.

Developing Asia, on the other hand, exhibits lower compliance, compared to the average for middle income countries. Most countries in the sample were materially non-compliant or non-compliant in principles regarding information sharing between supervisors, ownership, prudential regulation and requirements, on-site and off-site supervision, remedial measures, and cross-bordering banking. In addition, no supervisor in the sample practiced consolidated supervision or incorporated country risk control.

International Association of Insurance Supervisors (IAIS) Principles

On the insurance side, both developed and developing Asian countries in the sample outperform their peers. Main weaknesses for the insurance supervisors around the world lie in corporate governance standards, internal controls and market conduct. In general, Asian systems assessed exhibit the same deficiencies as in other regions, except that all countries in the sample complied with the market conduct principle.

International Organization of Securities Commissions (IOSCO) Principles

Developed Asia in general has implemented or broadly implemented most principles. A few partially implemented principles relate to independence and accountability of the regulator, oversight of self-regulating organization (SROs), and capital and other prudential requirements for market intermediaries.

In developing Asia, securities regulators often lack sufficient capacity and consequently do not conduct proper market surveillance. Moreover, no country in the sample had adequate rules and procedures to detect and deter manipulation and other unfair trading practices. Improvement is also needed in the area of information sharing with other supervisors, the use and oversight of SROs, standards for collective investment schemes, and regulation of market intermediaries.

Committee on Payment and Settlement Systems (CPSS)

Payment systems in developed Asia appears to be of high quality, while compliance in developing Asia is only partial. Most systems, including both large value transfer systems and check clearing systems, in the sample of developing Asian countries do not have sufficiently well-founded legal basis and still lack risk management procedures, prompt final settlement, security and reliability and governance arrangements. In addition, supervisors often have limited capacity to oversee payment systems that the supervisors themselves do not operate.

Appendix II.5. Asian Regional Policy Forums

EMEAP (Executives Meeting of East Asia and Pacific Central Banks)

Established in 1991 as a forum of central banks, aiming at enhanced regional surveillance, exchange of views and information, and financial market development. Currently, there are three Working Groups: WG on Payments and Settlement Systems, WG on Financial Markets, and WG on Banking Supervision.

11 members. Australia, China, Hong Kong, Indonesia, Japan, South Korea, Malaysia, New Zealand, the Philippines, Singapore, and Thailand. The secretariat function is offered by the BOJ.

ASEAN (Association of South East Asian Nations)

Established in 1967. It has slowly grown from its original five members to current 10 members. The group’s economic cooperation covers; trade, investment, industry, services, finance, environmental protection, agriculture, forestry, energy, transportation and communication, intellectual property, small and medium enterprises, and tourism. Since 1999, meetings among representatives of finance ministries and central banks of ASEAN plus China, Japan, South Korea (ASEAN+3) have been held (initially the deputy level, then Ministers and Governors since 2000) to discuss topics such as, financial cooperation, regional surveillance, and human resource developments. A network of bilateral swap arrangement among ASEAN+3 countries is currently in place (Chaing Mai Initiative).

10 members. Brunei, Cambodia, Indonesia, Lao PDR, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam (original members in bold). Secretariat is located in Jakarta, Indonesia.

ASEM (The Asia-Europe Meeting)

Established in 1996. ASEM is an informal process of dialogue and cooperation bringing together ten Asian countries (see below) with the fifteen EU member states and the European Commission. It holds summit level meetings every two year and Ministerial-level meetings in the intervening years (normally once a year). It addresses political, economic and cultural issues, with the objective of strengthening the relationship between the two regions, in a spirit of mutual respect and equal partnership.

26 members. Brunei, China, Indonesia, Japan, South Korea, Malaysia, the Philippines, Singapore, Thailand, Vietnam, the 15 EU member states and the European Commission,.

SEANZA (South East Asia, New Zealand, Australia)

Established in 1956, one of the oldest and also the largest in terms of membership of the regional policy fora. It is a forum among central banks, to conduct intensive, biennial central bank training courses. The very diversity of this group, however, argues against its practicality as a platform for more intensive central bank cooperation outside the training area.

20 members. Australia, Bangladesh, China, Hong Kong, India, Iran, Indonesia, Japan, South Korea, Malaysia, Nepal, New Zealand, Pakistan, Papua New Guinea, the Philippines, Singapore, Sri Lanka, and Thailand.

SEACEN (South East Asian Central Banks)

Established in 1972. Initially a training and research organization for central banks, SEACEN has evolved from an informal grouping in the 1980s to a more substantive forum for discussion of central banking issues (became a legal entity in 1982).

13 members. Brunei, Indonesia, Fiji, South Korea, Malaysia, Mongolia, Myanmar, Nepal, the Philippines, Singapore, Sri Lanka, Taiwan, and Thailand. The SEACEN Centre is located in Kuala Lumpur, Malaysia.

APEC (Asia Pacific Economic Cooperation)

Established in 1989, originally meetings between only foreign/trade ministers. Finance ministers (central bank governors) began to meet annually since 1994.

21 members. Australia, Brunei, Canada, Chile, China, Hong Kong, Indonesia, Japan, South Korea, Malaysia, Mexico, New Zealand, Papua New Guinea, Peru, the Philippines, Russia, Singapore, Taiwan, Thailand, Vietnam, and the United States. The secretariat is in Singapore.

Six Markets Group (G-6, or G-4 plus 2)

Established in 1994. Initially, it consisted of only four major Asian financial centers (Australia, Hong Kong, Japan, and Singapore). Since 1997, China and the United States have been invited to attend the meetings as well. The group’s objectives include stability of the region’s financial and foreign exchange markets. Meetings are attended by Vice Ministers of Finance and Deputy Governors of central banks.

Appendix II.6. FSAP and ROSC Participation by Region


Prepared by Brian Bell, Mali Chivakul, Hemant Shah, Leslie Teo, and Yuji Yokoburi.


Instead of quantitative limits, trustees may invest in a security if it is one that would be bought by a prudent man of discretion and intelligence, who is seeking a reasonable income and preservation of capital.


This section is based on available data from formal standards and codes assessments (see Appendix II.4 for details) as well as other work done by the IMF and World Bank in Asian countries.


For the purposes of this appendix, developed Asia includes Hong Kong, SAR, Japan, Korea, New Zealand and Singapore (all countries or a subset of countries, depending on data availability of each standard). Developing Asia includes Bangladesh, India, Indonesia, the Philippines, Sri Lanka and Thailand. All assessments were done in FSAPs except those for Indonesia and Thailand.

Financial Integration in Asia: Recent Developments and Next Steps
Author: Mr. Leslie E Teo, Mr. David Cowen, Mr. Hemant Shah, Mr. Ranil M Salgado, and Mr. Alessandro Zanello