The big picture

For the financial systems of many emerging markets, the 1990s were a period of extraordinary transformation. One of the most notable changes, Donald Mathieson and Jorge Roldos of the IMF explained, was the increasing presence of foreign banks in emerging market financial sectors. Their paper found dramatic rises in foreign participation in Central Europe and Latin America, but a notably smaller increase in Asia.

According to Mathieson and Roldos, foreign bank interest in emerging markets is being driven by technology-induced economies of scale that have fueled intense competition for market share and a growing interest (and comparative advantage) in geographic and product diversification. While only a handful of banks are able to conduct global commercial banking, a number of banks, leveraging language and cultural affinities, have emerged as “regional evolvers.” For the emerging markets, a growing openness to foreign trade and investment has spurred a new willingness to reduce barriers to foreign participation in the financial sector, but Mathieson and Roldos noted that it has often been crises and the costs of recapitalizing banks that have triggered foreign entry.

And does a greater foreign presence provide emerging market banking systems with greater efficiency and stability? Mathieson and Roldos found that while foreign banks may not always operate more efficiently than domestic banks in mature economies, they consistently have higher profits and lower operating costs in emerging markets and are associated with lower profit margins and reduced operating costs in domestic banks in these countries. Data are surprisingly scarce, however, on the link between foreign banks and stability, and they draw no firm conclusions on whether foreign banks lend emerging market banking sectors more stability and lessen credit volatility.

One of the biggest questions for policymakers is what position parent banks will take if branches (a legal part of the parent bank) or subsidiaries (separately capitalized entities) run into trouble. Indeed, what happens to local banks if their foreign parent bank has problems of its own? These relationships, Mathieson and Roldos underscored, have yet to be tested in crises.

Foreign participation in the securities industries of emerging markets has been fueled by much of the same mix—technological advances, competition, development objectives, and postcrisis reforms—plus international and regional commitments. Ranjit Ajit Singh, Director of Malaysia’s Securities Commission and chair of Working Group 2 of the Emerging Markets Committee of the International Organization of Securities Commissions, reported on a survey of 17 emerging markets. The experience in these countries, he said, highlighted how important it was for countries opening their financial sectors to have a preparatory phase. In expectation of increased competition, countries should deregulate the domestic industry, promote industry consolidation and strategic partnerships, and strengthen institutions. It was also imperative, Singh said, to have a strong and facilitative regulatory framework in place.

In the wake of the February 2000 World Trade Organization conference in Seattle and the financial crises of the late 1990s, the road to a General Agreement on Trade in Services 2000 won’t be easy, admitted Pierre Sauvé of the Organization for Economic Cooperation and Development’s Trade Directorate. But in a paper coauthored with Karsten Steinfatt of the Trade Unit of the Organization of American States, Sauve suggested that developing countries have much to gain from this round. He urged them to use this opportunity to lock in ongoing domestic reforms through proper sequencing and precommitting to future liberalization in the financial sector.

On the ground

Taking a closer look at the products and services foreign financial institutions offer in these countries, Michael Pomerleano of the World Bank and George Vojta of the Financial Services Forum found that large multinational banks have the resources to offer the greatest range of products and services, make the largest investments, manage the most information, and rationalize costs and risks most efficiently. But they will not eliminate the role of domestic banks, which are in a position to make good use of their knowledge of local markets and their relationships. Foreign and domestic banks, they suggested, complement each other’s strengths.

Pomerleano and Vojta also observed a dichotomy in foreign bank operations in emerging markets. Citibank, HSBC, and Standard Chartered, for example, have developed strong local franchises that target high-end consumer and commercial operations. Others, such as JPMorgan-Chase and Deutsche Bank, are limiting their credit exposure and are refocusing on investment and private banking activities. But broadly, Pomerleano and Vojta concluded, foreign banks are poised to continue to play a significant role in developing local financial markets, entering into local partnerships to furnish global services, and providing expertise.

Why, asked Edward Graham of the Institute for International Economics, would any country not liberalize fast? The “infant industry” argument holds no water, he said, but there is a real question of “franchise value.” To operate properly, banks need to retain a certain value, and to do that, they need to be allowed a certain amount of monopoly rent. Graham suggested a loss of monopoly rights was not a big problem for emerging market banks unless they held a large percentage of nonperforming loans—in that situation, he said, the entry of foreign banks could “annihilate” heavily burdened domestic banks.

For emerging markets, then, there is a real “chicken and egg” question, Graham said. Do you ask foreign banks to help resolve nonperforming loans or do you deal with the nonperforming loans first? What you absolutely don’t want to do, he indicated, is postpone liberalization and not deal with nonperforming loans. If a country must postpone liberalization, Graham recommended setting tight and published deadlines for resolving the nonperforming loans. And for the country that proceeds with liberalization, he strongly suggested deregulating the domestic banking industry and significantly improving prudential regulation.

The insurance component of financial sector liberalization tends to get “short shrift,” Harold Skipper of Georgia State University noted, but it can play a key role in a country’s development. Insurance, he said, can help promote financial stability, substitute for or complement government security programs, facilitate trade and commerce, help mobilize savings, and allow risk to be managed more efficiently.

Skipper saw little likelihood of foreign domination in emerging markets and feared efforts to discourage foreign participation in high-end markets might reduce efficiency gains. Ultimately, Skipper said, the crucial role for the public sector is in ensuring reliability. This could be achieved, he said, by encouraging a competitive and solvent insurance market and by developing a regulatory system that stressed adequacy, impartiality, minimal intrusiveness, and transparency.

Perhaps no segment of the financial sector has been more transformed by technology than the securities market, but Benn Steil of the U.S. Council on Foreign Relations saw little evidence of this transformation in the advice given developing countries hoping to create or expand their securities markets. He urged developing countries to leapfrog the structures and technology of mature markets and embrace the “global efficient frontier in trading technology, exchange governance, investor access, and market structure regulation.”

Among other recommendations, Steil counseled developing countries to buy, lease, or pay for access to existing trading and settlement systems rather than build their own; make efficient operating costs the decisive factor in determining whether a local or foreign owner is appropriate; ensure that listing is a competitive business; and actively seek out cost-minimizing combinations of compatible trading and settlement systems.

Opportunities and risks

Revolution is an apt term for the scope and speed of the technological changes taking place in financial sectors, Philip Turner of the Bank for International Settlements said, and given the unpredictable nature and timing of these changes, uncertainty will be a certainty for some time to come. There will be significant implications for banks—notably, increased competition from nonfinancial institutions, substantial changes in the business model, and greater financial sector consolidation—and these and related developments are likely to pose major challenges to regulators.

Turner cautioned that banks’ risk-management processes will have to be adapted to e-finance, and prudential oversight will have to identify totally new challenges and find ways to harmonize different concerns and priorities across countries. He identified important new risk issues in four categories: business miscalculation (always greater in periods of profound technological change); operational risk (increasingly complex technology used by employees who do not fully understand it);location of the counterparty (the physical and/or legal location of e-finance firms will be difficult to identify); and systemic risk (common software dramatically increases the impact of accidents or sabotage).

For regulators, there will be critical, but different, issues. Turner indicated that in an “internet-rich” financial system, regulation must be more flexible, stress guidance rather than detailed rules, and rely more on improved disclosure requirements. With even large banks dependent on service providers, these will also have to be properly monitored. And with the internet vulnerable to accidental or malicious disruption, it is essential, he observed, to have effective backup and security systems in place. Given the blurring of lines between types of financial products and with e-banks vulnerable to fast-developing crises, the challenge for authorities will be to establish areas of responsibility and identify where coordination would be beneficial.

In his keynote address, Michael Mussa of the IMF expanded on the theme of opportunities and risks. Financial services, he explained, thrive on information, computation, and communication—all areas in which the e-revolution has transformed the speed, scope, and nature of doing business. Financial services always try to convey a sense of investment without risk, but make no mistake about it, he said, banking depends on leverage and has always been one of the riskiest of businesses.

Since an economy’s well-being is intimately tied to the health of its financial sector, there are good reasons, Mussa said, why public sectors intervene when financial sectors run into trouble. But that said, he added, there are unavoidable problems with this intervention. Even if properly disciplined, it can induce excessive risk taking (moral hazard), and the intervention provides only delayed discipline (and intervention without discipline can come at great eventual cost to the economy).

The expansion of financial institutions into new areas is likely to increase risk, Mussa suggested. When you liberalize rules and allow banks to dabble in unfamiliar activities, the results can be disastrous, he said, citing the savings and loan debacle in the United States and similar patterns of expansion and crises in emerging markets. He warned, in particular, of the potential for problems with large multinational financial institutions that have enormous exposures outside their home countries and engage in highly complex transactions. While Mussa said he knew of no imminent dangers, the modalities of dealing with a major crisis in which no home country authority had clear responsibility raised serious concerns.