These forces are interrelated and complex, no one can claim to fully predict the final outcome. So, is this the new paradigm of known-unknowns? That is, we know what the major drivers of change are, but we cannot forecast outcomes. So the key strategic challenge is how to deal with the known-unknown.
For the short term, the key priority is dealing with the fragile and volatile global economy. Stability is the priority for banks and regulators.
The strategic policy question is how to get the right balance between risk and return, stability and growth. Weaker banks will retrench, leaving room for the few stronger banks to take up market share.
In Asia, we have seen banks from the Asia-Pacific, notably Japanese, Chinese, and Australian banks, move into market space where European and US banks have pulled back. Asean banks are also shifting strategies to play a greater role to support their conglomerates in their regional expansions. If this regional banking trend continues, what are the implications for banks, regulators, and central banks?
While the region has so far remained relatively resilient to the first round impact of European bank deleveraging, there is significant concern about the second round impact via a slowdown in global trade and the world economy that will impact growth.
Another known-unknown in the short-term is the impact of interaction among various traditional and non-traditional policy measures, such as monetary policy, and prudential policy including macroprudential. As a result of this crisis, the acceptable policy space has been significantly widened. While these measures have merits in safeguarding financial stability, they could have complex and cross-border impacts.
Even on the monetary policy front, unconventional measures are becoming more conventional. Central banks in the major economies have increasingly used unconventional monetary easing. Though necessary to stabilise their economies at this juncture, these policies have the side effects of large and volatile capital inflows into Asia. This further complicates safeguarding of financial stability in other countries including those in Asia, and could, in turn, trigger some countries to resort to macroprudential measures themselves.
Thus, in terms of policy space, we are dealing with a new paradigm of expanded policy tools, with new transmission mechanism, and requiring their own policy framework and governance. So we need to recognise the need for cross-border coordination as well as flexibility in execution given emerging uncertainties.
Turning to more medium-term structural issues, major regulatory reforms _ especially Basel III, Financial Stability Board (FSB) reforms, and the Dodd-Frank Act _ are still a known-unknowns. We do know that they are designed to redress weaknesses that caused the crisis by enhancing capital and liquidity, while addressing the problems of procyclicality, and too-big-to-fail of the Systemically Important Financial Institutions. For this, their merits are well recognised. But these reforms will reshape the global financial landscape and raise the cost of financial intermediation. They will also have implications for cross-border level playing fields, regulatory arbitrage, and altering the risk profiles of banks. Therefore, we need to recognise the unknown elements, that is the elements whose full future impacts on financial markets and the global economy we don’t yet understand.
The latest review by the FSB of potential unintended consequences of regulatory reforms pointed to these concerns. Emerging markets have raised some concerns about the Basel III capital and liquidity frameworks. These may have negative impacts on domestic financial markets, increase bank costs, and thus reduce credit and financial market liquidity. There have also been concerns about the treatment of traditionally low-risk trade finance in leverage ratios which may impact growth and development.
Emerging Asia is predominantly bank-based; thus, Basel III will affect its financial intermediation relatively more than in the West, just at a time when financial intermediation is critical to support economic development and integration. Some of these standards are still under discussion, and the Asia-Pacific region already has a proactive regional strategy to help steer these regulatory reforms to reflect the context of our economic and financial markets.
With regard to over-the-counter (OTC) derivatives reform which aims to move OTC derivatives trading on to exchanges and see trades cleared through central counterparties, there are concerns regarding inconsistency of regulations between countries, infrastructure that is needed, and cost for users. For example, if national central counterparty is not a viable and efficient model for a small economy, then the cost of hedging would increase with higher risk weight under Basel III. Meanwhile, if derivatives are cleared overseas, through regional or global central counterparties, we need to consider implications for cross-border supervisory coordination, financial stability, and development of local financial markets and competition. On the related issue of Dodd-Frank Act, restrictions on proprietary trading of US banks could impact the liquidity of US dollar markets abroad, as well as the liquidity of foreign government bond markets which are the back-bone of their monetary policy operations.
Another key issue going forward is the balance of authority between home and host regulators. There are concerns about the proposal by the FSB on cross-border resolution of Global Systemically Important Financial Institutions (G-SIFIs). The concern is that some host regulators may not be included by the home regulators in the crisis management group or resolution planning, even if the institutions are systemically important in their jurisdictions.
We are glad to see the FSB taking initiatives to identify potential problems. Now is the time to work together on solutions in an inclusive manner. This is because the inclusiveness of the process assures acceptability and commitment, and reduces the uncertainty from unilateral action of individual countries. These international regulatory standards have no direct international enforcement power.
Before the global crisis, governance was based on discipline which came from market discipline, but now market discipline is diminished. Also the influence and discipline from the IMF programme or Financial Sector Assessment Programme may have been somewhat countered by the growing importance of regional financial assistance mechanisms with their own governance. Each country or region would be more likely to adopt these new standards if they buy into the rationale of the reform. Inclusiveness and coordination are therefore keys for commitment, and the pillars of the new governance for bodies such as the Basel Committee and FSB; this is perhaps the new Bretton Woods.
Turning to longer-term challenges and strategy, Asia’s increased economic importance will rise as a consequence of its development efforts in liberalising the economy and the financial system, and allowing market forces to enhance efficiency and productivity. These forces will accelerate with the increased integration of the Asean Economic Community, Asean plus 3, and plus 6.
For intra-Asian financial flows, Asia is not homogenous. North Asian and financial centre economies are developed, and some are mature economies facing their own challenges. The rest of Asia is emerging economies, some facing a middle-income trap, and some facing the transition challenges from centrally planned to market economies. Thus, regional financing and the growing role of regional-centric financial services will naturally follow.
The most critical challenge emerging Asia faces is to build economic and financial infrastructure fast enough to properly harness the growth energy and put these capital into productive use. Without adequate financial infrastructure, namely market and legal infrastructure, and financial literacy, there is potential risk that emerging Asia cannot absorb such flows. This could result in misallocation of resources, including asset bubbles and instability. In parallel, public investment in infrastructure projects, as well as social investments in education and healthcare, are keys for increased productivity and economic upgrade. The challenge lies in getting the right balance between growth and stability, in managing large and long-term financing, increasing public investment, while keeping financial discipline.
These are complex issues on how to ensure efficient resource allocation.
A key strategy is to enhance the role of Asian financial sector market mechanisms to rise to the challenge, and to act as check-and-balance on public policy.
We are at an important turning point where we face a paradigm shift. This is one of the realignments of relationships between the market, regulators, and society. In crisis countries, the balance of the relationship between the financial industry and society shifts because the costs of financial crises are born by society. In emerging Asia, public policy, including financial regulation, comes under pressure from social demand for financial access as well as consumer protection. These naturally accompany the take-off in growth as a result of economic and financial liberalisation.
Both banks and regulators need a proactive strategy to deal with the social and political environment that will shift banking environment and regulatory paradigm. Thus, the strategy for banks going forward must also include proactive governance and accountability frameworks that seeks to restore trust in market mechanisms, and improve the social and political environment in which they operate. Failing to recognise these powerful social forces will result in less than optimal regulations.
Similarly, the strategy for successful global regulatory reform is to assure an inclusive process, to garner commitment and credibility for reform.
In conclusion, the key strategy for dealing with this paradigm shift of known-unknowns is based on the three Cs:
FCoordination to deal with our interconnected financial stability.
FCommitment forged by inclusive global reform process.
FCommunal responsibility, or governance, that can regain society’s trust in market mechanisms, so that we can rebuild market discipline as a key governance aspect and pillar of the financial system.
These are our best hope for striking the right balance between risk and return, growth and stability, and regulation and market discipline at a time of known-unknowns.