This post, authored with David Kempthorne, first appeared on the CIGI blog, Wealth and International Politics.
On the sidelines of the IMF-World Bank annual meetings, the Toronto Centre, which is mandated with training regulators and supervisors from over 170 countries, hosted an enlightening conversation on whether regulatory and supervisory best practices can be taught.
Specifically, a panel was convened to discuss whether developed nations can and should be teaching "best practices" to developing countries. Is there some resentment among developing countries on being preached to about the best practices by developed countries when the latter missed the ball on negative spillovers of their own financial institutions?
Since the global financial crisis, many of the G20 members have listened to the G7 countries, particularly the United States regulators and supervisors, to propose a plethora of rules and regulations for all G20 countries to follow. These new rules and regulations are meant to shore up banking systems, liquidity ratios, and strengthen the Financial Stability Board to monitor the flow of capital.
This reflects previous post-crisis regulatory reform efforts in which developing countries are rule takers and G7 countries are the rule makers. All this in spite of the fact that the epicentre of the international financial crisis occurred in developed countries. So why should many of the regulators and supervisors in developed countries claim to know best practices for developing countries?
The Governor of the Central Bank of Sweden noted that the crisis provide some clear lessons for emerging market economies. The Governor believes that many emerging market economies had weathered the storm because they had high capitalization levels and low loan to deposit levels. With bank activities being more and more cross-border, these international standards are actually helpful. As the Malaysian Central Bank Governor stated, having global governance arrangements will allow the coordination across borders so there is no race to the bottom.
Perhaps more importantly, from a political standpoint, they provide a form of political insulation against domestic political pressure to weaken financial regulatory standards to promote investment and stimulate economic growth. For this purpose, the Basel accords give a good measurement rod for all countries to try and follow. This why the Malaysian Governor of the Central Bank believes that following best practices will, in the long term,[ help to promote balanced economic growth in the globe.
But were international capital adequacy standards the driver behind emerging market economies' strong capital buffers that protected against shocks from the financial crisis? As a Columbian supervisor noted, emerging market economies have been through financial crises before so they were better prepared in the last international financial crisis to withstand some of the negative spillover effects. He noted that his job involves closely monitoring Columbian deposits into Latin American banks. So regional banks have a large influence in many countries of the region, which requires an additional layer of cooperation and co-ordination of policies across borders. The Columbians have been working to identify how to deal with regional systematically-important financial institutions (SIFIs).
The critical issue facing emerging market economies in the post-crisis regulatory reform process has been questions about the suitability and applicability of international financial standards created predominantly by G7 countries. The Malaysian Central Bank Governor noted that her country did not see any of the disruptions of credit supplies or of financial markets coming from the international financial crisis. Some of the global rules and regulations devised in Basel as a result of the crisis have, however, had unintended consequence on her country. She noted how some of the rules and regulations do not have applicability to the context of emerging market economies and yet presumably can increase costs for the financial industry.
There are a number of issues in the run up to the crisis, which raise questions about whether developed market economies are in a position to teach emerging market economies about appropriate regulatory practices. The United States and the United Kingdom refused to subject hedge funds to mandatory registration that would enable regulators to understand the nature of their investments and concentrations of risk in OTC derivative markets. Developed market economies chose to allow banks and investment firms to merge, increasing the integration of financial firms, the concentration of credit risk and the creation of 'too big to fail' financial firms.
But critically, developed financial markets believed that sophisticated banks were able to assess the risk of their own balance sheets through internal risk models. These are some of the critical financial regulatory issues where financial regulators from developed economies have, in hindsight, failed to effectively govern the financial system. These regulatory failures give pause for thought about the appropriateness of developed financial markets being the rule makers after the global financial crisis.
The question of whether developed nations can and should be teaching best-practice standards to developing countries raises a number of important issues about the effective governance of international financial markets after the crisis. The most recent financial crisis highlights the limits of developed countries' financial regulatory regimes, as well as the hubris of regulators and financial markets alike about their knowledge of how to best govern financial markets. But, financial crises in emerging and developing markets in previous years highlight that developing markets are not immune from regulatory failure.
For the effective governance of financial markets going forward it is necessary for regulators from both developed and developing markets to have an effective two way discussion about the potential benefits of alternative approaches to financial regulation. Moreover, it is necessary for the international standards project to allow for nationally differentiated regulatory regimes that conform with international best practice principles. This will enable regulators to maintain high standards of financial regulation that reflect the unique structure of national financial markets and avoid unnecessary and unintended consequences for emerging economies.