Reflections on Financial Sector Reform Andrew Sheng Chairman - - PowerPoint PPT Presentation

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Lecture for Staff of Central Bank of Sri Lanka

8 April 2005 Colombo, Sri Lanka

Reflections on Financial Sector Reform

Andrew Sheng Chairman Securities and Futures Commission, Hong Kong

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Contents of Lecture

• Lessons of Financial Crisis
• Managing the Reform Process
• Sequencing / Prioritizing Reforms

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Historical Overview of Financial Crises

• 1980s and 1990s were decades of financial crises

– 1980s revealed external debt crises of Latin America and first signs of endemic NPLs in LDC banks – 1990s saw Mexican crisis, followed by Asian crisis, and then problems in Argentina – Asian crisis was not public debt crisis, but private debt crisis, hence consensus on key role of corporate governance – Asian crisis saw rapid contagion – local pain can cause global pain, hence strengthening of architecture

• Since then, considerable cumulative experience in crisis

management

– International financial architecture/surveillance strengthened at both domestic and IFI level, e.g. FSF and FSAPs – World Bank/IMF/BIS/OECD etc have greater technical experience and working together better – Greater awareness of importance of global standards, transparency and accountability at all levels

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Restructuring, Recovery and Fatigue

• Y2K and 9/11 2001 revealed operational risks from globally

linked markets – Markets are networks – Systemic failures are actually network failures

• Asian Restructuring since 1997 has been painful

– Costs up to 50% of GDP – Basically, private sector NPLs were carved out to AMCs and funded by public debt – Major emphasis on corporate governance reforms

• Generally Asia is in better shape after post-crisis reforms

and current recovery is gaining strength

• But why are NPLs still high despite growth?
• Are the problems more fundamental and structural?

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Banking Crises and Resolution

• Crisis is an event, the culmination of many

factors interacting together

• Bank restructuring and resolution is a process
• Process involves four major steps:

– Diagnosis – Damage Control – Loss Allocation – Rebuilding Profitability and Getting the Incentives Right

• How have we performed since Asian Crisis?

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What is a Financial Crisis?

• The eruption of an event (e.g. failure of a

corporation or financial institution) that triggers a systemic distress, panic or wealth loss that spreads within domestic markets or abroad

• Crises are caused by internal frailties or

weaknesses that allow systemic breakdown as a result of internal or external shocks

• Because financial system is a network, need to

distinguish between liquidity crisis [flow] from solvency crisis [stock]

• Banking system need lender of last resort,

precisely because Central Bank can step in to prevent a liquidity crisis from triggering a solvency crisis.

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Stocks and Flows of National Economy

• Financial system is “blood circulation system” of national
• economy. Financial network links the following four other

sectors together:

– Corporate sector – Household sector – Public sector – External Sector

• Each has its balance sheet and flow statements
• Financial sector fulfils four basic functions:

– Resource allocation – Price discovery – Risk Management – Corporate Governance

• Crisis occurs when weaknesses in real and financial sectors

are exposed by event/shock (globalization creates network shock)

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Vicious Cycle of Financial Distress

Asian crisis: private debt mismatches Latin American crisis: excessive public debt and inflation

Enterprises experience foreign exchange and loan losses Devaluation

• ccurs

The fiscal impact creates a need for bank recapitalization Commercial banks are decapitalized Central bank refinancing leads to money creation Inflation rises higher than the world rate

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Ultimately, Financial Crisis Ends Up as Quasi-fiscal Deficit

• Banks have implicit or explicit deposit insurance, i.e. moral

hazard risks

• Depositors or foreign creditors cannot absorb losses

without huge political implications

• Both banks or borrowers can be “Too Large to Fail” –

government is concerned that failure can have systemic problems

• Hence, banks or borrowers transfer their stock or flow

losses to the Government via Government guarantees, Asset Management Companies (AMC), or bail-outs

• Relationship is known as Troika model
• Borrower insolvency passed on to become bank insolvency

(NPLs) – if LOLR also perceived as insolvent (i.e. no dollars to settle local convertible currency), then capital flight

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Much Written on Bank Restructuring

World Bank:

• Financial Crisis and Financial Restructuring

– 18 papers presently posted on website

http://www1.worldbank.org/finance/html/fp-financial_crises_and_financ.html

• World Bank Finance Research: Bankruptcy and Resolution of Financial

Distress – 3 papers currently posted

http://econ.worldbank.org/programs/finance/topic/bankruptcy/

IMF:

• Lessons from Systemic Bank Restructuring

Claudia Dziobek and Ceyla Pazarbasioglu

http://econ.worldbank.org/programs/finance/topic/bankruptcy/

• FSAPs useful source on financial health

http://www.imf.org/external/np/fsap/fsap.asp

• David S. Hoelscher and Marc Quintyn, Managing Systemic Banking Crises,

IMF Occasional Paper (forthcoming)

• McKinsey (2003): Banking in Asia: Acquiring a Profit Mindset (2nd Edition)

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Crises have both Macro and Micro Origins

• Poor macro policies, e.g. fiscal deficits, inflation, balance of

payments deficits

• Weak institutional structures

– Lack of deep debt and capital markets – Lack of credit culture – Outdated laws, weak judicial systems – Poor corporate governance

• Lax enforcement, poor risk management, connected or directed

lending, weak loan recovery, deposit guarantees, and distorted tax policies all show up in weak balance sheets

• Weak players, low standards of performance and efficiency,

insufficient oversight and unclear rules of game, make financial network vulnerable to shocks

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Lessons of the 1980s’ Banking Crises

• Financial stability rests on maintaining stable currency
• Banks fail because of losses in real sector, compounded by poor

risk management and fraud

• Liberalisation overlooks wealth effects of relative price changes;

losses worsened by inadequate supervision

• Bank losses often become quasi-fiscal deficits
• Failure recognition is important as banking crisis is a solvency

problem, not a liquidity issue

• Stopping the flow of future losses is critical
• Method of loss allocation determines success of restructuring
• Success depends on sufficient real sector resources to absorb

losses, financial sector reforms, and budget’s ability to tax “winners” and wind down “losers” with monetary stability

• Good policies, reliable management and strong institutional

framework needed to rebuild safe and profitable banking systems

• Time and timing are of the essence

Source: Sheng (ed) Bank Restructuring: Lessons from the 1980s, The World Bank, 1996

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Asian Crisis vs 1980s lessons

• Stable currency vital – volatility concern in 1990s
• Real sector issues – crony capitalism blamed for poor corporate

governance

• Hasty liberalisation – balance sheet effects of interest rate and

exchange rate volatility overlooked

• Bank losses often became quasi-fiscal deficits – cost of resolution

up to 50% of GDP in crisis economies

• Solvency problem, not a liquidity issue – yes
• Stopping future losses critical – did not ensure bank standstill in

time

• Loss allocation – basically governments underwrote loss through

debt swap or AMC

• Reform success – by and large crisis over in three years
• Rebuilding safe and profitable banking systems – profitability back,

but so are bad habits

• Time and timing are of the essence – cannot be complacent

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How Good is Diagnosis?

• Institutional strengthening

– Coordinated surveillance by IFIs, FSF, FSAP – International standards set by BIS, IOSCO, IAIS, IMF – Strengthened supervisory framework and cooperation at national and international level

• Adoption and implementation of international standards by local

networks would strengthen overall network, eg IAS, OECD corporate governance codes, insolvency laws

• Generally getting better at diagnosis, but informational

difficulties remain:

– Asset valuation is difficult as there are no market prices for loans – Collateral valuation also serious problem in estimating provision needs – Inadequate provisioning due to tax changes that need reform – Banks generally reluctant to reveal extent of losses, unless forced by crisis or incentive to shift loss to AMC

• NPL estimates by market vary and at least double official data

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What is NPL?

• NPL is loss due to bad risk management of credit to customers

– Weak credit assessment – Poor collateral, either bad assets, fraud, or inability to recover assets due to poor insolvency laws – Loan forbearance, including provision of further loans hoping that borrower will recover

• NPL is revelation of economic losses, after application of IAS

and stringent loan provisioning according to Basle standards

• In most cases, NPLs reflect losses that have already incurred

[stock losses]. Forbearance means unwilling to face revelation.

• Damage Control means that banks or supervisors must have

systems in place to minimize further losses and exposures to problem borrowers

• Consequently, NPLs are actually revelation of inefficiencies or

losses of bank creditors, when they get marked to market using international standards. The quality of corporate governance determines the level of inefficiencies and hence NPLs.

• Alternatively, NPLs arise because of unclear property rights, so

that borrowers pass losses to banks and then to the State

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NPLs in Asia Still High

As at the end of 2001* $ billion % of total net loans China 345 25 Japan 346 9

• S. Korea

8 4 Indonesia 4 12 Malaysia 14 11 Philippines 6 17 Thailand 9 11 India 14 11 Taiwan 32

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Source: McKinsey & Company’s Asia Financial Institutions and Corporate Finance &Strategy practices (2003), Banking in Asia Acquiring a Profit Mindset (2nd Edition)

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NPLs Likely to Increase

• In 2002, Ernst and Young [NPL Loan Report: Asia 2002] estimates

Asia’s NPLs at $2 trillion, up 33% and double official estimates – Japan accounts for $1.2 trillion or 60% – China accounts for $480 million or 25%

• As a percentage of GDP, the estimated NPLs range from about

12% to 45% of GDP

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Damage Control

• Because NPLs derive from real sector exposures, they

can be minimized in two ways:- – (a) Restrict further bank lending (quick fix) – (b) Work on changes in corporate governance and debt recovery (long haul solution)

• You must stop both the stock and flow losses
• Faster IFI response with better recognition that no

“one size fits all” solution can apply

• Selective bank closures or foreign entry helps to keep

domestic banks on their toes

• The fact that NPLs have been reduced in some

economies does not mean that they will not revive if structural issues (e.g. poor borrower solvency, connected lending, weak corporate governance, policy distortions, weak institutions, political instability) are not resolved.

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Stemming New NPLs

• In China, McKinsey studies suggest that despite strong growth, 5-

8% of loans turn sour within first year (pp 15).

• Unless credit culture improves, NPLs will rise, particularly with

focus on collateral rather than cash flow

– 80% of bank retail accounts in Japan lose money (McKinsey, pp 48)

• Incentives must be right, e.g. separate social lending from

commercial lending so that management is accountable

• Market discipline must be strengthened –

– Weak companies can be taken over, i.e. markets must be

• contestible. High PE ratios discourage takeovers.

– Mispricing of risk: spreads are too small relative to risk. McKinsey suggests bank spreads in Japan must double from 125 basis points to 250 basis points (pp 48) – Make profits in line with International norm for ROA of 1.2%. McKinsey studies: 0.4% in China, 0.8% in S. Korea, overall weighted average ROA of 0.9% for Indonesia, Thailand, Malaysia and Philippines (pp 61, 106, 189) – Greater transparency and disclosure: less than 15% of top companies in Asia have credit ratings (McKinsey, pp 17)

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Loss Allocation

• Political economy of loss allocation:

– Who should bear loss – shareholders, borrowers, banks, employees, depositors, external creditors, government? Ultimately, state bore most of losses [e.g. in one Indonesian bank, state took out US$19.8 bn out of $25 bn assets, before it was sold to foreign joint venture]

• Liquidate or restructure banks:

– market solution or government intervention? Mixed approaches: closures, mergers, nationalisation, foreign investment and government bailouts

• Key concern is fiscal sustainability:

– unresolved NPLs, as quasi-fiscal deficits increases contingent liability of budget and therefore become potential future tax burden

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Why is NPL Resolution Slow?

• Rule of thumb:

– Outstanding (stock) NPLs of 5% is acceptable; 10% considered a problem; 15% and above, a disaster – New (flow) NPLs of around 2% p.a. normal

• Low interest rates make banks reluctant to dispose collateral, and

also help sustain non-viable firms, delaying corporate restructuring or exit. E.g. McKinsey estimates that 20% of Japanese corporations have not repaid principal in over a decade and loans are rolled over (pp 48)

• No incentive for banks to restructure once loans provisioned
• Organisational culture that focuses on blame rather than

corrective action results in compromised decisions that do not deal decisively with problems in order to evade responsibility.

• Strong resistance from vested interests
• Hope to grow out of problem. McKinsey estimates China needs to

grow 20% p.a. for the rest of decade to bring NPL down to 5% of

• utstanding loans (pp 110)

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Fiscal Sustainability

• inflation, growth and budget
• Fiscal sustainability of debt, and hence success of bank

restructuring, depends on rate of inflation, growth and level

• f budget deficit.
• The change in government debt to GNP ratio (d):

Change in d = (primary deficit/GNP) – (seigniorage/GNP) + d (real interest rate – growth rate) [Fisher and Easterly]

• Low inflation, high growth and low fiscal deficits or small

surplus economies will see d decline over time. E.g. Malaysia, Spain and Chile

• Large primary deficits and excessive real interest rates

result in unsustainably huge debt ratios, leading to

• hyperinflation. E.g. Argentina and Yugoslavia
• Change in d also depends on whether NPLs are checked

and bank losses stemmed

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Rebuilding Accountability and Getting

Incentives Right

• Retaining old bank management in place, and simply carving out

NPLs without changing incentives could lead to new NPLs. McKinsey study suggests that Asian focus has been on consolidation rather than profit.

• Success of restructuring depends on implementation of the right

incentives for self discipline and market discipline to work based

• n risk return considerations, supported by regulatory discipline,

i.e. effective enforcement that promotes observance of rules and regulations.

• So far, performance of AMCs mixed. Historically 1 of 3

restructuring agencies successful and 2 of 4 rapid asset disposition agencies successful [Daniela Klingebiel, World Bank]

• Progress on enterprise or corporate restructuring has been
• uneven. Risk that bad borrowing habits are creeping back in.

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NPLs Reflect Weak Property Right Infrastructure (PRI)

• Why would borrowers want to repay debts if:

– Property rights are unclear? – If businesses can pass losses to government? – Courts do not enforce collateral? – Bankers can be bribed? – Banks would not pursue them?

• Why would banks want to recover loans or recognise bad loans if:

– If bank staff are underpaid, under-trained and cannot enforce loan recovery? – Borrowers have strong political influence? – Loan classification rules are unclear, and auditing and accounting standards are not stringent? – Supervision and enforcement are weak? – The state will bail them out?

• Hence, NPLs are a reflection of weaknesses in the PRI

– Bank restructuring process assumes that well functioning PRI exists to minimize NPLs after carve out. – If PRI is still dysfunctional, NPLs will still flow.

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Efficient Market Economy Means Building a Robust PRI

• 1. Delineation of property rights

– Property rights need to be clearly defined and legally protected

• 2. Enforcement of property rights

– Property rights need to be protected and enforced efficiently, fairly, and predictably through independent judiciary and regulatory systems

• 3. Culture in respecting law, property rights and contracts

– Credit culture means respect of law, property rights and contracts, and they are rewarded for doing so

• 4. Reform of market institutions that protect rights

– The systems of accounting, regulation, judiciary and property registration (e.g. land and equity registration systems) need to brought up to international standards in order for markets to perform efficiently, fairly and transparently

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Architecture of PRI

• Delineation of property rights: Information, Standards, Codes,

Rules, Laws, Contracts, lodged in custody: by owner, agent/trustee, bank, registry

• Exchange of property rights: DvP – holder must notify broker,

registrars [e.g. land registry, share registry], custodians, banks, lawyers etc

– Trading [e.g. stock exchange or OTC] – Clearing, settlement and payment infrastructure – clearing house and payment system

• Protection of Property rights:

– Intermediaries have to be regulated for discipline against misconduct – Clear Rules of Game – norms, standards, codes, regulations, law, transparent to all participants – Enforcement Infrastructure – enforcement costs cannot exceed benefits to market – Independent and transparent judiciary to adjudicate property disputes

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Process to Manage Reform

• Asia has implemented many reforms, but outcomes may

not always be on target.

• Reform fatigue could have set in resulting in no follow

through to ensure successful implementation.

• Law of unintended consequences may frustrate reform

efforts and generate reform resistance.

• Reform is a process, but we need a process to manage

the reform process so that it stays the course and departures from path can be put back on track through set procedures.

• Reform needs ownership of the need for change.
• Process to manage change is an important area that

deserves more attention by policy makers.

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Change is the only Constant:

Reform is Inevitable

• Change is being forced on all economies because of:-

– Globalization and Competition – Technology – Trade and Financial Liberalization – Transition from command to market economies

• Either prepare for change or face financial crisis
• After Asian crisis, there is reform and recovery
• But reform fatigue is setting in and in several

economies, NPLs keep flowing.

• Why are reforms not as successful as expected?
• Have we truly resolved root causes of Asian crisis?

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Political Economy of Reform

• First rule of politics: It’s the economy, stupid!
• First rule of economics: It’s the politics, stupid!
• Brings home that –

– Crisis is an event, restructuring is a process. – Finance is a derivative of the real sector as the financial system intermediates between the real sectors and amplifies structural weaknesses. – NPLs reflect inefficiencies in the real sector, revealed as Asian bank-dominated financial system exposure to borrower (corporate or public sector) inefficiencies which are increasingly marked to market using international standards. – NPLs reflect both stock of past losses, as well as flow of new losses!

• Therefore, NPL only a symptom of inefficiency, not the

cause of crises.

• We need to get to root causes of crises if we are to fix

the problem.

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Markets, Networks and Property Rights

• The economy is a network of markets – banks, capital markets,

retirement funds, real estate, consumers and investors, producers, government services, etc – that interact with one another to generate output, employment and growth

• Market is a network across which property rights are defined,

delineated, exchanged, protected and enforced by market participants (inc. SROs and regulators)

• Network stability depends on integrity [solvency] of participants,

strict network standards, clear rules of game, and network

• versight [supervision/regulation] to ensure network operates

efficiently and remains stable

• As domestic networks converge with global networks, differences

in standards, conduct, and weaknesses in interconnectivity, interoperability creates shocks in system that can be inter-active

• In other words, market stability requires network stability, and

depends on property rights integrity!

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Restructuring Financial Systems = Rebuilding Networks

• Foundation for well-functioning markets and networks is a PRI:

standards, codes, rules, laws, and institutions such as judiciary, regulators, service providers and intermediaries that define, delineate, transfer and protect property rights.

• Network failures occur where:

– Participants fail [liquidity & solvency risk]; – Operating system fail [operational risks] – Rules of game unclear [legal and regulatory risks] – Conduct unbecoming [integrity risks] – Lack of transparency [information asymmetry] – Weaknesses in interconnectivity and inter-operability add to transaction costs and risks.

• In global competitive game, most robust network with lowest

transaction cost and protected property rights wins!

• Therefore, key to reforming network is to understand network

architecture!

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Asian Reform Issues

• complex, multi-dimensional architectural

issues

• Problems in financial system have both macro and micro origins –

bad policies, weak institutions, lax enforcement, poor risk management and governance, and inadequate national laws to deal with cross-border issues.

• Financial sector reforms on their own are not enough. The integrity
• f financial system depends on integrity of real sectors through

network effects.

• Issues are complex, requiring reforms on many fronts. But, the

need for reform has first to be recognised, accepted and championed.

• Resistance to change is natural and has to be managed to avoid

loss of momentum or backtracking of reform

• Good policies do not necessarily lead to good results. Success or

failure depends on the plan of execution or implementation.

• The how of reform is as important as the what of reform:
• There is need for Process to Manage the Reform Process!

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Emerging or Mature Economies Face Same Issues of Maintaining Sustainable Growth

• First, how to evolve an efficient public sector that delivers public

goods with minimal corruption and without excessive tax burden?

• Second, how to nurture a vibrant corporate governance culture, so

that private enterprise can grow without rent-seeking activities that are harmful to public (consumers, investors, employees)?

• Third, how to build a property rights infrastructure that is

transparent, fair and efficient in protecting both public and private property rights?

• Fourth, how to balance public and corporate governance at a level

that mobilizes private sector energy as a domestic engine of growth, and a public sector that supports sustainable growth with equity and justice?

• Actually, technology to manage change already available at

corporate and some mature economy levels.

• Technocrats rush in, where angels fear to tread!

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Management of Change

• Why are Asian reform outcomes not always on target?

– Resistance from vested interests – Inadequate resources, financial and human – Lack of support for, or understanding of benefits of, reform. Reform needs ownership to be successful. Consultation of stakeholders key. – Lack of coordination and monitoring – Law of unintended consequences may frustrate reform efforts and generate reform resistance

• Is current bureaucratic structure appropriate to implement

reform? Managing change, e.g. reforms to become a market economy, requires different skill sets.

• Reform is a process, but we need a meta-process to manage the

reform process so that it stays on course and achieves desired

• utcomes.
• Even IFIs realize how difficult and complex organizational change

management has become: doctor, heal thyself!

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• “The central lesson that emerges from this story of

the boom and bust – that there needs to be a balance between the role of government and of markets – is one which evidently the world has to learn over and over again.”

• “When countries got that balance wrong, veering

either towards too much or too little government, disaster happened.”

• “Today, the challenge is to get the balance right

balance, between the state and the market, between collective action at the local, national, and global levels, and between government and non- governmental action.”

Nobel Laureate Joe Stiglitz: Roaring Nineties Allen Lane, 2003

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• People, exchanging
• Products [property rights], using
• Process, e.g. trading, clearing, settlement

software, across

• Platform - hardware infrastructure/network

carrying messages, under

• Prudential Rules of the Game [that protect

the property rights].

What is a Market?

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• Information Asymmetry – participants do not have equal

information, and therefore incur different risks and transactions costs in searching, analysing and trading property rights

• Incentive Compatibility – different players have different

needs and incentives – market matches their needs [supply & demand]

• Adaptive and Feedback – market participants learn and

forget (herding): behaviour is influenced by incentives and enforcement of rules and laws

• Disciplined Pluralism – the more players, the more

competition, the more innovation and creativity

• Spontaneous Order – no one designs the market: it

evolves

• Path Dependent – where you go depends on where you

start from (historical legacy and conditions)

John Kay: Truth about Markets

Penguin 2003

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• “A modern economy is far too complex to be

managed by any one agency or power”

• “The market constitutes, so to speak, an infinite

number of small, partially dependent computers, linked in parallel processing, each in possession of most (though probably all) of the information needed to make a correct decision, precisely because it is a small and local decision”.

• The market works precisely because its mistakes are

localized…– its greatest strength is that it minimizes threats and mistakes”

• But – “the market presupposes a social framework.

It also presupposes an effective government, and (as is proven now by a great deal of historical research) a functioning market requires respect for, and legal assurance of property rights.

Peter Drucker: Raison d’etre of Free Markets

Drucker on Asia, Butterworth 1997

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• Free Entry of Participants and Products;
• High degree of transparency/low information

asymmetry

• Efficient Operations by solvent participants under

international rules of the game at low transaction costs;

• Absence of incentive distortions or bias that moves

market in unhealthy direction e.g. moral hazard or subsidies;

• Efficient regulation at low regulatory costs;
• Orderly exit of insolvent participants [obsolete

products and insolvent operators create huge dead costs on market]

•  Accountability [feedback and exit for bad players]

Efficient Markets require:

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• Free flow of information – good media coverage;
• Efficient regulatory bodies, including police and ICAC

type institutions

• Clean and efficient judiciary to adjudicate property

disputes

• Property registries: e.g. stock register, land registry

that are transparent to market participants;

• Professionals in the legal, accounting and commercial

services area, who provide competent advice and services to market participants;

• Good investor/ consumer education

Property Rights Infrastructure = Governance Structure for Markets

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Source: FSAP: Experience and Issues Going Forward, Stefan Ingves, Economic Forum, 16 December 2003

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Policy objectives must be clear

• The goal of financial regulation is to influence the

behaviour of intermediaries so that the policy

• bjectives are achieved.

Regulatory Cycle Policy Objectives ⇒ Processes ⇒ Policy Outcomes ⇒ Policy Review

• Ability to clearly define objectives, lay down

effective processes and achieve desired policy

• utcome critical to credibility of regulator
• Need good feedback in order to fine-tune policy and

processes, ie transparent, timely and accurate information.

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Types of Financial Regulation

• PRUDENTIAL REGULATION: ensuring that

market participants have adequate capital and liquidity and are fit and proper (e.g. bank regulation operates through banks)

• CONDUCT REGULATION: ensuring that market

participants behave within ethical and statutory rules that does not impose harm on market (e.g. securities regulation impacts not only on securities intermediaries, but also conduct of responsible officers)

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Policy, Process and Outcome

Process Outcome Loopholes Policy Target

• r

“Problem” Unintended Effects

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Regulation is Trade-off between Gains versus Risks or Costs

• Cost of Regulation
• Resources spent to apply it + Burden Imposed on

Firms + Law of Unintended Consequences

• Benefits of Regulation
• Reducing market failure and externalities
• Preventing bad behaviour
• Zingales: “necessary to do an overall calculation of the
• verall benefits of regulation versus its overall costs”*
• Uncertainties:- Information often not available. Response of

market participants uncertain and subject to lags

• Need framework to work out Policy Options + Standards to

measure costs and benefits

* Luis Zingales, “The Costs and Benefits of Financial Market Regulation”, European Corporate Governance Institute, April 2004

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To Reform or Not Reform

No market misconduct or

• fraud. Little or no

regulation

• required. Market

and issuers exercise self- discipline. High incidence of market misconduct and fraud. Impose more regulation to punish perpetrators and deter future misconduct. Benefit of regulation

< costs of regulation

ð Don’t reform

Benefit of regulation

> costs of regulation

ð Reform

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Policy Option Matrix: who gains, who loses?

Will investor benefit? Are risks concentrated in households? Education? Households Consumer Investor Employee Investors shift abroad? More barriers? Entry policy change? Foreign What are costs

• f supervision?

Quasi-fiscal deficit? Regulatory checks & balances? Government Bureaucracy Will behavior change? Conflict of interest Supervision? Intermediaries Behaviour change Vested interests Disclosure? Competition policy? Firms Flow Stock Impact Tool Stakeholder/ Sector affected

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Using Different Levels of Discipline

• Self Discipline - self regulation, using standards

and codes – getting SROs and NGOs to work

• Regulatory Discipline - can be imposed by SROs
• r by statutory regulators - with civil or criminal

sanctions [but has high costs]

• Market Discipline - contractual discipline

through courts, openness to market competition and clear exit mechanisms

• All three disciplines are necessary to achieve

good corporate governance and efficient markets

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Sequencing or Prioritizing Reforms

• Most reformers try to do too much too quickly
• Reformers [and IFIs] forget that implementation

capacity is very limited – the vested interests and resistance to change can be very large

• The path to hell is paved with good intentions –

if you do not understand good intentions do not necessarily lead to good outcomes

• Listen to the small man – very often, reforms do

not work because in most cases “people closest to the work knows the work best”.

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New and Old Wisdoms

Harvard Professor Malcolm Sparrow, The Regulatory Craft:-

• “Pick important problems, fix them and then tell everybody.”

– Don’t just focus on the urgent, focus on the important! – “In a crisis, don’t pick all problems, pick the top three” Dr Nordin Sopiee, ISIS Malaysia – Take care of big problems, the small will take care of themselves!

• “The essence of the [regulatory] craft lies in picking the right

tools for the job, knowing when to use them in combination, and having a system for recognizing when the tools are inadequate so that new ones can be invented.”

• Old Chinese saying: 實事求是 Seek Truth from Facts or Get

Real!

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Peter Drucker on Reinventing Government

Drucker on Asia, Butterworth 1997

• “To reform something that malfunctions (let alone something

that does harm) without knowing why it does not work can

• nly make things worse.”
• “Two things required to renew government:
• Building continuous improvement into government;
• Concentrating government on what works, and

abandoning what does not work”.

• “Continuous improvement and benchmarking are largely

unknown in government agencies. They would require every agency – and every bureau within it – to define its performance objective, its quality objective, and its cost

• bjective. It would require defining the results that the

agency is supposed to produce.”

52

Peter Drucker on Reinventing Government

Drucker on Asia, Butterworth 1997

• “In every developed country, there is a crisis of government
• today. The public is totally disenchanted”
• “The megastate that this century has built is bankrupt,

morally as well as financially. It has not delivered. But its successor cannot be ‘small government’.

• “We need effective government – and that is what the voters

in all developed countries are clamoring for….in every country, governments are becoming less effective when we need them to be more effective”

• “In every country the question of what government can do is

rapidly becoming the central question – and one which nobody has yet taken seriously or has yet studied.”

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Concluding Thoughts

• Reformers need to understand the nature of the problem that

they are trying to solve, their own capacity to solve them and the process by which reform can be managed and be

• effective. Focus on the outcomes, not just the objectives.
• Applying international standards is important, because they

allow the measurement of the size of the problem, as well as the benchmarks by which results are measured:-

• Are NPLs really declining?
• Are banks accounting alive and economically dead?
• What does the customer really want?
• Does the financial system really serve the needs of the

customers?

• Globalization has benchmarked all domestic financial
• systems. Even reformers are benchmarked, not on good

intentions, but on results.

54

Thank you very much