Regulating Emerging Markets

Lessons from the financial crisis.

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567480_shanghai_roadThe speed and breadth of contagion from the U.S. financial crisis have dramatically demonstrated the degree to which national economies, developed and developing alike, are intertwined. Initially a problem confined to the U.S. housing market, the rapid spillover of the crisis to the rest of the U.S. financial system and then to the global economy left financial institutions in other advanced economies reeling. The crisis has generated momentum on substantive regulatory reforms geared toward ensuring the integrity and resilience of financial systems in the advanced economies.

The macroeconomic consequences of the crisis have also affected emerging markets and other developing economies, even though this group has rebounded more quickly and sharply from the crisis (see Kose and Prasad, 2010). These shared ramifications have brought into even sharper relief the centrality of sound financial systems for emerging markets as well as low-income developing economies. Efficient and stable financial systems are essential for both emerging markets and low-income developing economies to achieve long-term balanced development and to absorb various types of shocks.

It is striking that the crisis emanated from the United States and hit particularly hard a group of economies, including that of the United Kingdom, that were once believed to have the most sophisticated and robust financial systems. These developments have led to a reevaluation of basic principles of financial regulation. Clearly, a reconfiguration and strengthening of existing regulatory models and frameworks would improve financial stability. The necessary paradigms are still evolving although there appears to be a general consensus on some key principles that will be central to a major redesign of financial regulation.

Emerging market financial systems, including those in Asia, generally have proven to be more robust and less affected by the global turmoil compared to their advanced economy counterparts. It will be important to carefully filter out the right lessons from this outcome. Meanwhile, the imperative of financial development remains as strong as ever in emerging markets although the focus is more on basic elements, such as strengthening banking systems and widening the scope of the formal financial system, rather than on creating sophisticated instruments and innovations.

Emerging markets face particular challenges in stabilizing their nascent financial systems in the face of shocks, both domestic and external. These challenges occur at a basic level in emerging markets, many of which are at the point of creating sound banking systems, widening inclusion in the formal financial system, and creating and managing a broader set of financial markets (such as corporate bond markets and basic currency derivatives). Thus the regulatory challenges in these economies are more about risks emanating from underdeveloped financial systems rather than risks from sophisticated financial innovations.

New paradigms for financial development and regulation will have to be suitably reframed for emerging markets, which have a number of varying institutional and capacity constraints. Regulation in low-income countries, where the breadth of formal financial systems is severely limited, poses an even greater set of conceptual and practical challenges.

Policymakers in emerging markets will need to grapple with a distinct set of issues once the recovery in the global economy is entrenched and attention can turn to the steps needed to restore financial stability. The following are some of the key issues facing policymakers and regulators in emerging markets:

—What lessons does the crisis offer for the establishment of efficient and flexible regulatory structures? Even the advanced economies have had to confront these deep structural questions, which tend to be more complex in emerging markets due to inadequate regulatory capacity and weak legal and public institutions.

—How can the regulatory and financial development agendas be reconciled in a manner that creates regulatory space for the introduction of standardized products and the development of broader financial markets while effectively managing the associated risks? The financial development agenda is an important one in emerging markets where efficient financial intermediation remains a major challenge, with implications for general economic welfare.

—Is broader financial inclusion consistent with financial stability? In general, increasing financial inclusion—extending access to the formal financial system to a greater swath of the population—is a key issue for emerging markets at this critical juncture. Financial inclusion has many implications for allowing households to save and diversify their sources of income, enabling entrepreneurs to have access to financing, and creating a more efficient system of intermediating domestic savings into investment.

—What avenues should be pursued to enable effective regulation of financial institutions with large operations in multiple countries? Foreign banks and other financial institutions have become key players in many emerging markets and have provided a number of direct and indirect benefits to local financial systems. However, in times of externally induced crises, they may prove to be a source of contagion.

This essay focuses on evaluating the lessons from the crisis and on designing effective strategies for maintaining the momentum of financial development and inclusion in emerging markets, with a particular focus on Asian emerging markets. It attempts to assess the implications of the financial crisis for the design of regulatory frameworks and models, taking into account the specific constraints in emerging markets. The main areas covered in this paper are:

—Basic principles of financial regulation: synthesizing evolving paradigms on the key characteristics of optimal regulatory structures to promote financial stability.

—Financial regulatory reforms in emerging markets, with a focus on emerging Asia: dealing with the challenges of limited institutional development and regulatory capacity.

—The financial development agenda: improving financial intermediation and creating space for the development of broader financial markets, including basic derivative products.

—Financial inclusion: how to increase the access of households and entrepreneurs to the formal financial system in emerging markets and considerations of whether greater inclusion is consistent with promoting sound regulation.

—Optimal macroeconomic policy frameworks to enhance financial stability: challenges in designing robust monetary policy frameworks, particularly in light of de facto increasingly open capital accounts.

—Cross-border financial regulation and, more broadly, regulation of financial institutions that have a substantial presence in emerging markets.

(Source SSRN. Download the full paper here)

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