Report Of APEC Finance And Central Bank
REPORT OF APEC FINANCE AND CENTRAL BANK DEPUTIES ON STRENGTHENING INTERNATIONAL FINANCIAL ARCHITECTURE
A well-functioning international financial system is essential to allow an efficient allocation of global savings and investment, and provide the conditions needed to improve world-wide growth and living standards in all economies. Recent events in the world economy have demonstrated that a strengthening of the system is needed to maximise the benefits of, and reduce the risks posed by, global economic and financial integration.
In this increasingly integrated global economy, in which policy responsibility still lies mainly with sovereign states, the challenge is to promote global financial stability through national action as well as through enhanced international cooperation. All economies, together with the international financial institutions and private sector financial institutions, face this challenge together.
A major international effort is underway to strengthen the International Financial Architecture in order to make future crises less likely and to deal better with those that do occur. This effort entails identifying policies to help markets work properly and to provide the public goods necessary to achieve this objective. It requires public authorities to provide for enhanced transparency and disclosure (including by private institutions), improved regulation and supervision of financial institutions and markets, and policies to protect the most vulnerable. It also requires that private creditors and investors bear responsibility for the risks that they take, and are involved appropriately in crisis prevention and crisis management. In these respects, the establishment of internationally-agreed codes and standards for policy-makers serves both as an incentive for better governance and as a yardstick against which to measure performance and risk.
APEC Leaders had in their declaration in November 1998 tasked the Finance Ministers and their Deputies to prepare this report on the reform of the international financial architecture.
This report has been divided into seven sections, reflecting the issues identified by the leaders:
I. Prudential regulation of financial institutions in industrialized economies, including regulation concerning highly leveraged institutions and Offshore Financial Centres.
II. Transparency and disclosure standards for private sector financial institutions
III. Capital Flows
IV. Enhancing Supervision and Deepening Financial Markets
V. Improving Crisis Management
VII. Strengthening Social Safety nets
Progress in many of these areas has been facilitated by the creation of the Financial Stability Forum to enhance international cooperation and coordination in the area of financial market supervision and surveillance.
I. Prudential Regulation of
Financial Institutions in Industrialized Economies
The Leaders attached special urgency to examining the scope of strengthened prudential regulation of financial institutions in industrialized countries and to encouraging sound analysis and better risk assessment in their declaration in November 1998. The Leaders also called for the examination of the implications of the operations of highly leveraged and off-shore institutions.
The recent difficulties in some member economies have served as a reminder that investors and other creditors often tend to underestimate risks as they reach for higher yields. Excessive risk taking, combined with high degrees of leverage, can magnify the negative effects of any event or series of events. Measures to induce creditors and investors to act with greater discipline (i.e. to analyze and weigh risks appropriately in their lending and investment decisions) should aim at avoiding excessive leverage and encouraging more prudent assessment of risks.
Measures to improve risk assessment and risk management
Measures to induce creditors and investors to act with greater discipline, such as increased supervisory oversight of firms’ risk management practices and strengthened capital adequacy, can dampen investors’ tendency to underestimate risks in good times and exaggerate them in bad times.
The Basle Committee recently agreed on proposed revisions to the Capital Accord to make it more sensitive to risk - including credit risk involved in lending to emerging markets and in short-term lending - and reflecting compliance with international standards such as the IMF’s SDDS (Special Data Dissemination Standards) and Basle Core Principles. The Basle Committee also intends to consider broader revisions to the existing systems of risk-based capital regulation, taking into account changing market practices. The Basle Committee, International Organization of Securities Commissions (IOSCO) and International Association of Insurance Supervisors (IAIS) have established Core Principles for supervision in their respective areas of responsibility. IOSCO is working to strengthen risk management practices for securities firms in relation to highly leveraged institutions and is considering other measures for reducing counterparty risk in dealing with highly leveraged institutions.
Concerns have been expressed about the impact of highly leveraged institutions, especially hedge funds, on market dynamics generally and on vulnerable economies in particular. This highly complex issue is being analyzed by the Financial Stability Forum’s working group on highly leveraged institutions, which responds to the Leaders’ November 1998 declaration and which has representatives from a number of APEC economies. The working group has been asked to investigate the challenges posed by highly leveraged institutions to financial stability in both developed and developing economies. The working group has also been mandated to take stock of work that has been completed or is underway; to establish what is being done to implement recommendations already made and consider the need for further impetus to enhance implementation; to make recommendations, where necessary, on improving coordination between existing organizations working in this area; to identify issues that have not been covered in existing work and propose suitable procedures for dealing with them; and to foster a consensus on substantive supervisory or regulatory actions which may be needed to minimize the destabilizing potential of highly leveraged institutions and to facilitate the implementation of the recommendations. It plans to issue its report early next year.
Offshore financial centres can pose risks to international financial stability, and have the potential to undermine the effectiveness of strengthened regulation in onshore markets. Therefore, it is important to ensure that they comply with international standards.
The Financial Stability Forum has established a working group on offshore financial centres, which will evaluate the impact on global financial stability of the activities of market participants operating in OFCs. The working group has been mandated to review progress made by offshore centres in enforcing international prudential and disclosure standards. It will also assess the progress made in complying with international agreements on the exchange of supervisory information or information relevant to combating financial fraud and money laundering. The above information will enable the Working Group to evaluate the threats to financial stability or to the credibility of regulatory efforts that arise from continued non-compliance, non-enforcement and non-cooperation by offshore centres. The Working Group can then evaluate the scope for improving compliance and cooperation through technical assistance to, and/or intensified regulatory or supervisory contacts with, offshore centre authorities, and take other appropriate action, including supervisory reactions in the case of non-compliance and non-cooperation. The Working Group will issue its report early next year.
II. Transparency of the
The Leaders expressed the importance of examining questions of appropriate transparency and disclosure standards for private sector financial institutions involved in international capital flows. Private sector transparency is of particular importance to the orderly and efficient functioning of financial markets. The principles established by the Basle Committee, IOSCO and IAIS include principles related to transparency. Valuable actions in this area also include IOSCO’s issuance of Disclosure Standards to Facilitate Cross-Border Offerings and Initial Listings by Multinational Issuers. IOSCO is reviewing the advisability and feasibility of imposing transparency and disclosure requirements on highly leveraged institutions. The International Accounting Standards Committee has completed its core set of international accounting standards, which are now under review. The Committee on the Global Financial System (CGFS) is reviewing ways to improve market disclosure, including a model template for public disclosure of their exposures and risk profile by institutions engaged in trading, investment and lending activity, both regulated and unregulated.
III. Capital Flows
The Leaders noted the importance of promoting safe, sustainable capital flows to those member economies which faced severe capital flight in the recent past. Capital flows have to some extent returned to these economies, suggesting increasing market confidence in the ability of the affected economies to return to growth in the near future. Net private capital flows to Asia are projected to recover to $29 billion in 1999 from $8 billion in 1998.
Capital Account Liberalization and Controls
A bias towards short-term capital – particularly in foreign currencies - left a number of economies particularly vulnerable to shifts in investor confidence. Economies should rely more on long-maturity, and if possible domestic-currency denominated, debt to maintain a debt profile that provides substantial protection against temporary market disruption and should avoid transforming long-term debt into short-term debt. Economies should work to remove biases which encourage short-term private borrowing.
It will be important to consider the experience of countries with controls on capital. The use of controls on capital inflows may be justified for a transitional period as economies strengthen the institutional and regulatory environment in their domestic financial systems. Where financial sectors and supervisory regimes are weak, safeguards may be appropriate to limit foreign currency exposure of the banking system. More comprehensive controls on inflows have been employed by some economies as a means to shield themselves from market pressures and their experience may provide some insights. However, they should not be used as a substitute for reform, and there is a need to establish whether the benefits outweigh the costs. In addition to these considerations, controls on capital outflows may carry even greater long term costs, although they may be necessary in certain exceptional circumstances. Many economies have found that they have not been a very effective policy instrument, though it will be important to study the impact of recent experience. They should not be a substitute for policy reform.
The need to continue work on Capital Flows
The potential problems associated with volatile capital flows have not gone away. The Financial Stability Forum working group on short term capital flows has been mandated to evaluate prudential policies, regulations and risk management (including debt management practices) in borrowing economies that may help reduce the risks to financial systems associated with the build-up of short-term external indebtedness; to identify any regulatory or other factors that may have introduced an unwarranted bias in favor of short term flows, and recommend action to reduce such bias; to review progress in improving the adequacy and timeliness of the data and reporting systems on which authorities and investors rely to monitor and assess risks associated with capital flows, and give impetus to improvements as needed and to evaluate other potential measures in debtor and creditor economies to reduce the volatility of capital flows and its adverse consequences for financial system stability. It plans to issue its report early next year.
IV. Enhancing Supervision
In their declaration, APEC Leaders emphasized the importance of developing strong, resilient and well-regulated domestic financial markets within the framework of a stable international financial system.
APEC Finance Ministers urged member economies to strengthen efforts to implement the Core Principles established by the Basle Committee, IOSCO and IAIS, including in the context of the Core Principles Methodology Working Group and with appropriate involvement by the IMF and the World Bank. They encouraged member economies relatively advanced in meeting the Core Principles to share their experience and practical knowledge with other interested economies.
Work is underway to compile into a common reference the various financial and economic policy standards and best practices that have been developed in part in response to the financial difficulties experienced by a number of countries in recent years. A compendium on international financial and economic policy standards, through which economies could articulate their intention to implement the various standards and best practices, is being developed under the auspices of the international regulators and the international financial institutions.
During the Finance Ministers’ meeting in May 1998, the APEC Finance Ministers endorsed Action Plans that outlined assessments of the adequacy of existing training programs for bank supervisors and securities regulators and identified inadequacies in the management of training processes in some of the APEC members’ financial regulatory authorities. The Advisory Groups on training of bank and financial supervisors have developed specific plans for carrying forward the implementation of the measures in the Action Plans. In their May 1999 statement, Finance Ministers noted that the capacities of APEC supervisory and regulatory authorities must be continually upgraded and thanked the ADB and the SEACEN centre for their support in implementing the Action Plans for the Training of Bank Supervisors and Capital Market Regulators. The results of the survey on adequacy of banking supervisory regimes of the APEC members conducted by Malaysia have been encouraging.
V. Improving Crisis Management
The Leaders in their November 1998 declaration called for further work on improving crisis management, including orderly debt workout arrangements with the private sector.
Official Sector Improvements
The IMF Supplemental Reserve Facility (SRF) and Contingent Credit Line (CCL) should play an important part in promoting financial stability. This facility aims at protecting from contagion countries with reasonable debt structures, sound macro-economic and structural policies, and which are also engaged in an appropriate process of consultation with their private creditors. The facility should encourage the IMF towards an increasing focus on crisis prevention, and will provide further incentives for countries to take early measures to avoid the risk of financial crisis. The CCL provides an additional mechanism for encouraging countries to implement standards and codes of good practice.
Economies should take ex ante steps to strengthen the framework for the market-based, cooperative and orderly resolution of the debt payment difficulties that do arise. Appropriate communication between debtors and creditors is important in both crisis prevention and resolution. Emerging market economies should develop mechanisms for more systematic dialogue with their main creditors. Market-based tools aimed at preventing crises and facilitating adjustment to shocks, including through the use of innovative financial arrangements, including private market-based contingent credit lines in emerging economies and roll-over options in debt instruments, could facilitate access to the international markets in times of instability for emerging economies, and, in the context of a sound debt management framework, help mitigate liquidity crises and give economies a breathing space to make decisive macro-economic or structural adjustments.
Private credit decisions need to be based on an assessment of the potential risk and return associated with a particular investment, and not on the expectation that creditors will be protected from adverse outcomes by the official sector. Governments should narrow the scope of their guarantees of private obligations and make those explicit, so as to make sure that creditors do not lend to private entities with the expectation that the government will ultimately stand behind loans to the private sector.
The G-7 Finance Ministers recently released a broad framework of principles and tools for involving the private sector in crisis resolution. The framework should help to promote more orderly crisis resolution and therefore be of mutual benefit to debtors and creditors in finding cooperative solutions. It should also help to promote cooperative solutions between borrowing economies and the private sector and to shape expectations in a way which reduces the risk that investors believe they will be protected from adverse outcomes. Developing a framework of this kind which facilitates debtor/creditor cooperation should minimise the incidence and intensity of crises and also minimise the time before financially troubled debtor economies can expect to regain market access after a crisis. The G-7 Finance Ministers asked the IMF further to develop and define the legal and technical questions involved in implementing specific approaches identified in the framework.
The APEC Leaders also observed that there would be considerable value in continuing the work on the reform of international financial architecture in a process involving both developed and developing economies. A number of APEC member economies were represented in seminars of 33 economies to discuss the reform of the international financial architecture. A Bonn seminar in March 1999 focussed on the importance of sustainable exchange rate regimes and consistent macroeconomic policies, the development of new ways to respond to crisis (in particular greater private sector involvement in crisis containment and resolution) and assessed the proposals for strengthening the IMF and the World Bank. A seminar held in Washington DC in April, studied the issues of prudential oversight, strengthening emerging market financial systems and strengthening social policies.
The Financial Stability Forum has been expanded to include several additional APEC economies. As noted above, the Forum has established working groups to focus on three issues: the implications of highly leveraged institutions, offshore financial centres, and capital flows. These Working Groups include some APEC and other economies that are not members of the Forum. The reports are to be completed early next year.
More recently, the G-7 has called for the establishment of an informal mechanism for dialogue among systemically significant economies within the framework of the Bretton Woods institutional system. The G-7 also has called for improving the effectiveness of the IMF and other international financial institutions, including IMF surveillance and programs so that they better reflect the changes in the world economy, in particular potentially abrupt large-scale cross-border capital movements.
Strengthening Social Safety Nets
The APEC Leaders identified as a matter of high priority the intensification of efforts to address the social impacts of crises. In particular, the Leaders attached importance to formulating strategies of concrete actions aimed at strengthening social safety nets.
Recent events in member economies and elsewhere have underlined the important link between economic and social issues. Good economies depend on stable relationships between governments and their citizens and strong social cohesion. Effective social policy helps provide the foundation for sustainable development by sharing the benefits of globalization more widely, equipping people for change and by fostering more robust economies.
Effective social policy can ease the costs of adjustment, especially if these costs fall most heavily on the poorest sections of society. Policymakers must make difficult choices during downturns between safeguarding immediate social welfare payments and programs and making the adjustment necessary to promote stable growth, which is ultimately the best way of reducing poverty and improving welfare.
Since many economies, including many member economies, are likely to face similar pressures, there is a case for identifying principles, policies and best practices, and for their promulgation through international organizations. The World Bank, in collaboration with the United Nations, has prepared principles of good practice in social policy. All economies must work together with the international financial institutions to develop and promote practices in social policies that most effectively support economic development.
The World Bank will report at the 1999 Annual Meetings on policies and best practices to protect the poorest groups and maintain the momentum for development. The G-7 has urged the IMF to consider the degree to which a country’s adjustment program provides for adequate spending in the social sector when assisting economies to improve macroeconomic frameworks in times of crisis.