Will the current financial turmoil change the financial architecture in Asia?

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ImageIt has been a long time since I’ve written, but the past two months have been quite hectic for us!  I just returned from China, where we were working with the capital market supervisor, and the issue of the financial sector regulatory architecture, or how market supervisors should be organized, was a topic of discussion.  In early June, there was a conference with all of the key financial supervisors on the topic of integrated regulation and supervision, and again, the policy makers are keenly focused on this issue now.

Across Asia, this topic has largely been in the background since the years immediately following the Asian crisis in 1997-1998.  However, the sub-prime mortgage crisis in the United States, beginning in the summer of 2007, has once again brought this issue to the forefront of policy discussions among Asian financial supervisors, particularly those in the developing economies.  Given the global turmoil and the new domestic challenges in emerging Asia (i.e., high inflation, rapid credit growth, and equity market turbulence, etc.), effective supervision of financial institutions and markets is clearly a hot topic.

This most recent financial crisis unfolded rapidly, impacted the largest and most sophisticated financial institutions in the world, and the duration and ultimate ramifications of the crisis is still unknown.  In Asia, the direct exposures of financial institutions to sub-prime-related instruments and risks appear to have been limited as most institutions were not active in this market segment.  In addition, the financial markets in Asia have not witnessed the same level of financial innovation as in the US and Europe with a more limited range of complex structured products. 

However, the financial market turmoil in the US, the failure of major institutions, such as the investment bank Bear Sterns, and the regulatory response to the crisis has caused market supervisors across Asia to question western models for financial regulation and to question the adequacy of their own systems. 

Some of the primary factors that contributed to the crisis included low interest rates, rapid credit growth, increasing leverage and use of short term funding in particular cases, the pooling of credit assets into complex structured products, poor assumptions and models for risk (with particular weaknesses in the credit ratings), the increasing use of off-balance sheet vehicles by banks, failures in governance structure and processes, weaknesses in risk management systems, regulatory gaps in coverage of various financial products, and supervision failures to adequately monitor the risks.  Some of these risk factors also exist in emerging Asia today and thus, financial supervisors across Asia are struggling with how to move forward in improving supervision to potentially prevent a second Asian financial crisis. 

In April 2008, the Financial Stability Forum (FSF) recommended actions in five areas and these are being studied carefully across Asia.   The question that is still largely unanswered by the FSF is what structure the global regulatory system should take on to better handle such crises in the future.  It has become apparent to many countries that the fragmented US model of financial regulation, with multiple national, state-level, and self-regulatory bodies, did not work effectively in the recent sub-prime crisis and the system is in need of reform.  In March 2008, the US Treasury Department issued the "Blueprint for a Modernized Financial Regulatory Structure," which proposed a major restructuring of the US financial regulatory regime, in part as a reaction to the financial crisis.  However, this Blueprint does not go that far in consolidating financial market supervisors and still largely leaves the institution-specific form of regulation in place instead of moving to a functional form of regulation (for instance, where a securities-related product is regulated by the securities regulator regardless of whether it is offered by a bank, brokerage, or insurance firm).
Financial supervisors in emerging Asia have also been looking to the primary example of the consolidated regulatory system – the Financial Services Authority of the United Kingdom.  Again, this model has also been questioned by Asian financial market supervisors given its recent weaknesses in the identification and handling of the failure of Northern Rock bank in the fall of 2007.  Thus, both models of financial regulation failed to prevent significant financial crises, despite the fact that the US and UK largely follow the internationally accepted best practices for financial market supervision. 

So, the question is what should Asian financial market supervisors do?  Should they wait until the dust settles from the current crisis to see if a particular model emerges that is viewed as the most effective at handling such crises?  Does the structure matter or is the efficacy of regulatory enforcement really the key?  Alternatively, is the financial sector simply naturally prone to financial crises, regardless of the regulatory and supervisory structure?  The World Bank has already hosted a conference on this topic in recent years, but what else should international institutions, such as the World Bank, do now?  Is there a role?


James Seward

Senior Financial Officer

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