trade and development report, 2015financial regulatory reform after the crisis 89 in the post-crisis...

UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENTGENEVA

TRADE AND DEVELOPMENTREPORT, 2015

UNITED NATIONSNew York and Geneva, 2015

Chapter IV

FINANCIAL REGULATORy REFORM AFTER ThE CRISIS

Making the international financial architecture work for development

Financial Regulatory Reform after the Crisis 87

in the aftermath of the 2008−2009 globalfinancialcrisis,politicalleadersacknowledgedthattherewereseriousshortcomingsinthewayfinancialmarketsandinstitutionshadbeenregulated.Thiswasamplydemonstratedbythefailureoflargeprivatebankstomanagerisk,theuncheckedexpansionofashadowbankingsystemandtheexcessiverewardschemes common throughout the entire financialsector.initially,theyshowedawillingnessforfun-damentalreformofthesystemaimedatmakingitmorestable,lesspronetocrisesandmoreresilienttoshocks,aswellastoorientitmoretowardssup-portingtherealeconomyandeconomicdevelopment.Theyalsorecognizedtheneedtoaccommodatetheinterestsandconcernsofthelargerdevelopingecono-miesinthedesignofanysubsequentreformagenda.Thusinlate2008,theG8wasreplacedbytheG20,which includes the largerdevelopingcountries,asthemostrelevantforumforinternationalcoordina-tionanddecision-making.SomeofthesecountrieswerealsogivenmembershipintheFinancialStabilityboard(FSb),whichsucceededtheFinancialStabilityForum(FSF)tocoordinatetheactivitiesofvariousfinancialstandard-settingbodiesandtotakechargeofmonitoringimplementationofthefinancialreformsagreedbytheG20countries.

ThereformprogrammecoordinatedbytheFSbaimed at strengthening prudential regulation and

theoversightandsupervisorycapacitiesoffinancialauthorities.However, today, sevenyears since theeruptionoftheglobalcrisis,ithasbecomeclearthat,apartfromsomepartialimprovements,ithasbeenunabletoeffecttherequiredchanges.Theexistingfinancialstructuresstilllackadequateinstrumentstoreducethevolatilityofcapitalflows,preventsystemiccrisesandensurethatfinanceisavailableforsmallandmedium-sizedenterprises(SMes)andinnova-tion.Reformsintroducedafterthe2008−2009crisishave takenonly a limited account of someof thespecificneedsofdevelopingcountries.

Thischapterdiscussessomekeyfinancialreformsagreedattheinternationallevelandwhichareintheprocessofbeingimplementedbynationalauthorities,and assesses their possible impacts, particularly indevelopingcountries.Sectionb,whichexaminesthenewbaselcapitalrequirementsaimedatstrengthen-ingbanks, shows that they still rely excessively onnarrowlydefinedprudentialrulesasthebestapproachto banking regulation.The section also examinesa number of initiatives to reform thefinancial sys-tem indeveloped countries.SectionC studies theshadowbankingsystemandtheproposedmeasurestomitigaterisksarisingfromthisformoffinancialintermediation.SectionDassessesotherimportantissuesforfinancialregulation,suchastheexcessiveuseoftheratingsofcreditratingagencies(CRAs),

Chapter IV

FINANCIAL REGULATORy REFORM AFTER ThE CRISIS

A. Introduction

Trade and Development Report, 201588

thechallengesarisingfromthegrowingpresenceofforeignbanksindevelopingcountries,andtheneedtoaddressthevulnerabilitiesarisingfromspeculativeinternationalcapitalflows.Sectionearguesforthe

needforamoreambitiousreformagenda,includingthenecessaryseparationorring-fencingofsomebankactivities.italsodiscussestheregulatoryelementsofamoredevelopment-orientedfinancialsystem.

B. Post-crisis financial reform and prudential regulation

over the past 40 years, the financial sectorhasexpandedsignificantlyandinternationalcapitalmobility, in particular, has soared following suc-cessivewaves offinancial innovation andmarketderegulation.Globalliquidityandtheallocationofglobal fundinghavebecome influencedmore andmorebycreditconditionsinmajorfinancialcentres,bytheoperationsoftheinternationallyactivebanks,andbytheactivitiesofawiderangeofassetmanage-mentcompaniesandotherinstitutionalinvestors.

Financialderegulationincludedtheprogressiverelaxationofquantitycontrolsandotherrestrictionsonbanks,suchascapsoninterestratesorlimitsontheabilitytoengageinactivitiesother than traditional lending.one aspect of such deregula-tionwastheretreatfromdirectgovernmentinterventioninthefinancial sector and the ero-sionof instruments to achievedevelopment targets. in theirplace,alight-handedregulatoryapproach based on prudentialrules(i.e.requiredcapitalizationandliquidityratios)gainedprominence.Thecentraltenet of this approachwas that banks should beallowedtofreelyallocatecreditorengageinmarket-basedactivitiesprovidedtheyholdsufficientcapitaltocopewithunexpectedlosses.Marketcompetitionwassupposedtoensuretherightfundingforprofit-ableinvestments,andthereforeahighsocialreturn.

Sincetheirintroductionin1988,baselcapitaladequacy requirements have become an impor-tant reference for prudential policies, not only in

countries represented on thebaselCommittee onbankingSupervision (bCbS)−originallya smallnumberofdevelopedcountries−butalsoinalargenumberofdevelopingcountries,eventhoughtheywerenotpartytotheformulationprocess,andeventhoughtheguidelineswerenotconceivedwiththeirfinancialsystemsinmind.1ThebaselAccordsseektopreventinternationallyactivebanksfrombuildingbusinessvolumewithoutadequatecapitalbacking.Theyalsoaimtoremovetheincentiveforindividualjurisdictionstoimposelessdemandingrequirementsonthebanksinordertoattractbusiness.Thebaselrulesreflectedthebeliefthatmarketsandfinancialentitieswere capable of self-discipline, and that

prudent behaviour by a bankwas integral to its reputationalcapital.Assuch,marketforceswereexpectedtopreventbanksfromtakingexcessiverisks.

Theglobalfinancialcrisisof 2008−2009,whichwas byfar theworst since the 1930s,revealedtheseriousshortcom-ings of financial deregulation

andoftheconceptualframeworkbasedonacom-mitmenttofreemarketsandself-regulation(TDRs 2009 and2011).The narrow focus of prudentialregulationbasedoncapitalrequirementsforbanksfailed topreventwidespread turmoil in late2008.indeed,manyoftheworld’slargestbanksthatfullymetthebaseliistandardsin2008werecrippledbythesubprimecrisisanditsramifications,promptingvery expensive bailout packages by governmentsthatresultedinsignificantincreasesinpublicdebtandhighsocialcosts.

The global financial crisis of 2008−2009 revealed the shortcomings of the concep-tual framework based on a commitment to free financial markets and self-regulation.


inthepost-crisisreformprocess,aconsensusseemedtoemergethatinstabilitywasglobal,andthatinternationalcooperationneededtobestrengthened(TDRs 2009and2011;Haldane,2014).Theinterna-tionalreformagendaunderFSbguidancedelivereda number of initiatives, including the basel iiiAccords,specificprovisionsforthe“globallysystemicimportantbanks”andrecommendationstoimprove oversight of shadowbankingactivities.2

G20 countries agreed toprogressively introduce thenew standards in their regula-toryframeworks.However,thesourcesofsystemicrisk,thatis,theriskthatadefault,liquiditysqueezeorcrisisonagivenmarketwouldspreadtoothermarketsandeventuallydevelopintoafull-fledgedcrisis,arelikelytopersist,andthefragilitiesthatcontributedtotheglobalcrisisremainaseriousconcern.Thissectioncriticallyexaminesthespiritofthereformprocess,highlightingitsmainweaknessesandthechallengestheyarecreatingfordevelopingcountries.

1. The new Basel III Accords

ThebaselAccordsofferthemostcomprehen-siveregulatoryframeworkforthebankingindustry.3However,theyhavebeeninadequate,inseveralways,toensureastrengthenedfinancialsystem.Crucially,capitaladequacyruleshavenotpreventedhighlever-agenorpromotedmuchportfoliodiversification,andtheyhaveaddedtothealreadyprocyclicalnatureofthebankingbusiness,asnotedbyseveralanalyses(e.g.Slovik,2012).

in reaction to the crisis and to the increasedscrutinyitwasfacing,thebaselCommitteeagreedtoprovideanewregulatoryscheme“tostrengthentheresilienceofbanksandtheglobalbankingsystem”(bCbS,2011).Thepackageofreforms,announcedinoctober2010,knownasbaseliii,includesnewcapitaladequacyrulesandanumberofliquiditypro-visions.inaccordancewiththeagreedtimetable,G20countrieshavebeenintroducingthenewstandardssince2013,andhavetargetedfullimplementationoftheframeworkby1January2019.

With respect to capital rules, basel iii hasimproved the quality of the capital that banks arerequired to hold to better absorb potential losses.CommonequityandretainedearningshavebecomethepredominantformofTier1 capital,asthenewframework has eliminated the possibility to use

preferredstockanddebt-equityhybridstoboostcorecapital.

in addition,basel iii hasintroduced higher levels ofcapitalcomparedwithitsprede-cessor,baselii.Theminimumlevel for total capital require-ments remained at 8 per centofrisk-weightedassets,buttheproportion accounted for by

commonequityTier1was raised from2percentto4.5percentoftherisk-weightedassets.baseliiialso requires banks to hold “capital conservationbuffers”ofanamountequaltoatleast2.5percentoftherisk-weightedassets,alsointheformofcommonequityTier1capital,tobemadeavailableintimesof stress.Whenbuffers aredrawndownas lossesareincurred,banksarerequiredtorebuildthembyreducingdiscretionarydistributionsofearningsandexecutivebonuses.Takentogether,thesemeasureshavebroughtthetotalcommonequityrequirementsto7percentofrisk-weightedassets.Thenewframe-work alsogivesnational authorities thediscretionto request banks to uniformly adjust upwards thecapitalconservationbuffersbuilttocopewithstresssituations,when,intheirjudgement,creditgrowthresultsinanunacceptablebuild-upofsystemicrisk.Thiscountercyclicalbufferisimposedwithinarangeof0−2.5percentandalsoshouldbemetwithcom-monequity.

Another feature ofbasel iii is the introduc-tion of a non-risk-based leverage ratio, based onaminimumTier1capitalofat least3percentoftotalassets.Forthecalculationoftheleverageratio,banks’exposuresmustcoveron-balance-sheetitemssuchassecuritiesfinancingtransactions,aswellasoff-balance-sheetitemssuchasderivativesandlet-tersofcredits.

Finally,theproposedliquidityprovisionsinthebasel iii package include liquidity coverage ratio(lCR)andnetstablefundingratio(NSFR)require-ments.ThelCR aims to ensure that banks havesufficientshort-termliquiditytodealwithsituations

Many of the world’s largest banks that fully met the Basel standards were crippled by the subprime crisis, prompting very expensive bailout packages by governments.


ofstresslastinguptoonemonth.TheNSFRaimstohelpbanksdealwithliquidityissues,butithasatimehorizonofoneyear,focusingonthematuritystructureofabank’sassetsandliabilities.Thatis,itencouragesbankstoholdmorestablefunding(forinstancefromdeposits)aswellasmoreliquidassets(bCbS,2014aandb).Althoughportrayedasagreatleap forwardwhen compared to its predecessor,baselii,thesereformsareunlikelytomakebanksmoreresilient.

Since basel iii has not changed the risk-weightingframework,corecapitalhastobemeasured,aspreviously,againstrisk-weightedassets.Thismeansthat in thecalculationof theassets thathave tobebacked by the bank’s capital,onlyassetsdeemed tobeveryriskyareaccountedattheirfullvalue,while those consideredto be safer are considered atonlyaproportionoftheirvalue.This increases the incentiveto invest in low-risk-weightedassets that can be leveragedmuchmore than risky assets.4Atthemacroeconomiclevel,therisk-based approachmayhaveadverseconsequencesforemploymentandeconomicgrowth,becauseitdiscriminatesagainstSMes.Sincethesefirmsareperceivedtoposegreaterrisksthanbigfirms,bankswouldbereluctanttoextendcreditlinestothem(Moosaandburns,2013)whenchoos-ingaportfolioskewedtowardsassetswithlow-riskweights.Moreover,baseliiidoesnotquestiontherelianceonexternalratingsbyCRAsortheuseofbanks’ internal riskmodels to calibrate the risk-weights.5 it isnotclearwhy thebaselCommitteestillseesvalueinCRAs’ratingswhentheFSbitselfstatedthat“itisparticularlypressingtoremoveorreplacesuchreferences[i.e.toexternalcreditratings]wheretheyleadtomechanisticresponsesbymarketparticipants”(FSb,2010).

by retaining the system of adjustable riskweights,baseliiihasnotaddressedtheprocyclical-ityofbaselii.Whendefaultrisksareperceivedtobelow,whichislikelyduringperiodsofeconomicexpansion – as in the 2003−2007 growth period– credit ratings are upgraded, therebymoving theassets towards a lower risk category for capitalrequirements.This causes a reductionof requiredcapitalforthesameassetportfolio,therebyallowing

higherleveragingduringtheexpansionaryphaseofthecycle.Conversely,capitalrequirementsincreasesuddenlywhentheexpansionendsandbanks’assetsareperceivedtobemorerisky.Further,thebaseliiireformsfailtoaddressoneofthemorecontroversialcomponentsofpreviousbaselrules:banksarestillallowed tocalculate their regulatorycapital them-selvesasanalternativetotheuseofexternalcreditratings,whichmeansthattwodifferentbanks,eachusingtheirowninternalriskmodels,oftenendupwithdifferentcapitalneedsforsimilarassetportfo-lios.6Perhapsmostfundamentally,thebaselnormscontinuetorely,implicitly,onlargebanks’effectiveself-monitoring,ratherthanonexternalsupervision,basedontheassumptionthat“marketdiscipline”will

ensure responsible behaviourby financial agents.Yet thisassumptionisnowrecognizedtobeflawedandunrealistic.

Under the risk-weightedframework, institutions haveaccumulated an excessive lev-el of leverage. between theenforcementof thebasel risk-weighted capital requirementsin1992(baseli)andtheglobal

economicandfinancialcrisisin2008−2009,banks’ratio of total capital tounweighted assets steadilydeclined.Forexample,inasampleoflargeinterna-tionalbanks,theratiofellfrom4.8percenttolessthan 3 per cent between 1993 and 2008 (ingves,2014).7Thebaseliiileverageratio,supposedtoserveasabackstoptotherisk-basedcapitalrequirement,will improve thecapitalbaseonlymarginally.Setatonly3percentofunweightedassets,capitalmaybesignificantlybelowthelevelnecessarytoensurebanksareminimallypositionedtowithstandamajorshock(AdmatiandHellwig,2013).8

2. The proposed framework for systemically important banks

large, internationally active banks contrib-uted significantly to the global financial crisis of2008−2009.Their presence in different nationaljurisdictionsandtheircross-bordertradingactivitiesfacilitatedthespilloverofthecrisistovariouscoun-tries.Giventheirsize,complexity,cross-jurisdictional

Basel III introduced higher levels of capital requirements but retained the risk-weighted system and the reliance on credit ratings agencies, thus failing to prevent high lever-age and procyclicality.


presenceandinterconnectedness,theselargebankshave createdglobal systemic risks and challengesforregulators.

Their complex and intertwined operations,whicharedifficulttotrackbyfinancialregulators,andevenbythebanks’ownseniormanagers,arefarfromtransparent.Thesebankshavebecomesolargethatfinancialexpertsandpolicymakersconsiderthem“toobigtofail”,meaningthatlettingthemcollapsewouldcauseunbearabledamagetotheentireinter-nationalfinancialsystem.Thefiscalcostsentailedinbailingthemoutincaseofinsolvencywouldbeexorbitant,andwouldrequireahighlevelofinter-nationalcoordination,whichisdifficulttoachieve.

Theirinternationalexpansionandthelargesizeof their balance sheets are difficult to explain onefficiencygrounds(biS,2010a).instead,evidencesuggeststhatsuchexpansionwasfacilitatedbyanunderestimationofrisk,whichmighthavedistortedtheir incentives.The “too-big-to-fail” label givessuchbanksacompetitiveadvantagebasedontheirassumption that if they suffer huge losses fromengaginginriskybehaviour,theywillberescuedbythegovernment.inaddition,itgivesthemaccesstocheaperfundingsources,astheyareseenaslesslike-lytodefault.Anothercompetitiveadvantagearisesfromthefactthat,underthebaselframework,largebankscanchoose themostconvenientapproachesforcapitaldetermination.Theyhavetheresourcestousetheirownriskmodels,whichgivesthemflex-ibility to determine their capital requirements andholdlesscapitalrelativetosmallerbanksthatonlyhavethemeanstoadoptthesimplerapproachesforcapitaldetermination.

Atthenationallevel,theexpansionoftheactivi-tiesoflargebankshasbeenamajorreasonbehindbankingconcentration,especiallybetween1998and2007.inthepost-2008periodthistrendhasstoppedoverall,although ina fewcountries, including theUnitedStates, it continues, partly reflecting post-crisisgovernment-sponsoredmergers(chart4.1).

Since theglobalcrisis,systemicrisksassoci-atedwithlargebankshavebeenamajorconcern.AUnitedNationsReportrecommendedsubjectinglargefinancial institutions to additional capital require-ments(UnitedNations,2009).italsoproposedtheadoptionbygovernmentsofstronganti-trustpoliciesto discourage banks fromgrowing too big.other

bodieshave suggested similar regulatorychanges.Forexample,theG20,atitsWashingtonSummitinNovember2008,recommendedareviewofthescopeoffinancial regulations to ensure that all systemi-callyimportantfinancialinstitutionsareadequatelyregulated.Ayearlater,theG20Summitinlondonfurtherproposedthatcomplexfinancialinstitutionsbesubject tospecialoversight,andthatregulatorsbegivenaccesstorelevantinformationonfinancialinstitutions,marketsandinstrumentsinordertobeabletodetectpossiblefailuresorsituationsofstressthatposesystemicrisks.

Since 2011, the FSb has identified globalsystemically important banks (G-Sibs) using amethodology developed by thebaselCommittee(bCbS,2011).9ThelatestupdateofNovember2014identifies 30 suchbanks (all of them fromdevel-opedcountries,exceptthreefromChina),whichareexpectedtobuildagreaterlossabsorptioncapacityaswellastohavecrisismanagementgroups,cross-border cooperation agreements and disaster plans

Chart 4.1

ASSETS OF ThE FIVE LARGEST bANkS AS A PROPORTION OF TOTAL ASSETS OF ThE bANkING SECTOR IN

SELECTED ECONOMIES, 1998–2011(Per cent)

Source: Bankscope, Bureau van Dijk.

201020

30

40

50

60

70

80

90

100

1998 2000 2002 2004 2006 2008 2011

Eurozone JapanUnited Kingdom United States


(knownas“livingwills”).in2014,theFSbpresentedproposalstoenhancetheloss-absorbingcapacityofG-Sibsinresolution,accordingtowhichthesebankswouldfacecapitalsurcharges,leadingtototalcapitalrequirementsequalto16−20percentoftheirrisk-weightedassets.Thisismeanttoallowanorderlyresolution thatminimizes anyimpactonfinancialstabilityandensuresthecontinuityofcriticalfunctions.10

However,eventhesepro-posalsmay be insufficient toaddress the “too-big-to-fail”issue. First, the fact that loss-absorbingcapacityiscalculatedusing riskweights creates anopportunity for exercising considerable discretioninmeetingtherequirements.Second,itisnotclearwhethernationalregulatorswillcooperatewithouta globally agreedbank resolution regime; indeed,withoutsucharegime,therecouldevenbealocal-asset-seizingfrenzy todefendnational interests incaseofbankruptcy.

3. The prudential framework and developing countries

Sincetheirintroductionin1988,baselguide-lines on capital requirements have become asignificant reference for regulators throughout theworld.More than100 countries have adopted thebaseliguidelinesforcapitalrequirements(barthetal.,2006),andallthedevelopingcountriesthatareG20members,butalsoalargenumberofnon-members,haveimplementedthebaseliirequire-ments.Althoughmostofthesecountries adopted thebasel ii“standardizedapproach”,someofthenon-membersoftheG20(e.g. bahrain,Malaysia andThailand)alsoimplementedthemorecomplexinternalratings-basedapproach,allowinglargebankstodeterminecapitalrequirementsonthebasisofaself-assessmentofrisk.AccordingtotheFSb’sassessment of implementation of the regulatoryreformsinNovember2014,allthemajordeveloping

economies that are FSbmembers have alreadybecomefullycompliantwiththenewbaseliiicapitaladequacyrules.11AmongotherdevelopingeconomiesthatarenotFSbmembers,adherencetobaseliiihasbeenratherweak(biS,2014and2015).12Table4.1summarizesthedegreeofimplementationofbaselii

andiiiindevelopingcountriesbyregion.

Theadoptionofthebaseliicapitalrequirementsbyalargenumberofdevelopingcountries,and the steps they have takento complywith the basel iiiarrangementsissomewhatpuz-zling.Afterall,implementationof thebasel recommendations

isvoluntary,andthebaselCommitteedoesnotpos-sess any formal supranational supervisory author-ity.Moreover,manydevelopingcountries thatareadoptingbaselstandardswerenotevenpartytotheformulationprocess.indeed,baselguidelineswerenot conceivedwithdeveloping countries inmind;theywereconceivedforcountrieshostinglargeandcomplex,internationallyactivefinancialinstitutionswiththepurposeofharmonizingnationalregulations(Powell,2004).

Nonetheless, therearevarious reasons for thepartialadoptionofbaselrulesbydevelopingcountries.Sincetheirintroduction,baselprincipleshavecometoberegardedbypolicymakersastheglobalsealofapprovalforthequalityofcountries’bankingsupervi-sionsystems.Manydevelopingcountries“imported”regulatorycredibilityasaresultofofficialandmarketpressures,especiallythoseeconomieswhoseregula-toryframeworkscameunderscrutinyfollowingthe

financialcrisesofthelate1990sandearly2000s(Walter,2008).inaddition,somelargedevelop-ing countrieswhich joined theG20cameunderfurtherpressuretoimplementbaselregulations.All theG20 countries, includ-ing the developing-countrymembers, agreed to allow theFinancial SectorAssessmentProgram (FSAP)13 to conduct

ananalysisoftheirdomesticfinancialsector−whichincludesanassessmentoftheirobservanceofbaselguidelines−aswellastoacceptpeerreviewsoftheirsupervisoryframeworks(Walter,2015).

Given their size, complexity, cross-jurisdictional presence and interconnectedness, large banks have created global systemic risks and challenges for regulators.

Basel guidelines were con-ceived for countries hosting large and internationally active financial institutions; they do not consider devel-oping countries’ needs.


implementation of the newbasel iii capitalrequirements by themajor developing economiesmaynothavebeenparticularlydifficultbecause,ingeneral, their banking systems had higher capitallevelsbeforetheglobalcrisisthanthosestipulatedinbaseliii.14However,thispictureisnotuniform.inindia,forinstance,publicbanks,whichaccountfor 62 per cent of indian bank loans,will find itdifficult tomeet thebaseliiicapitalrequirementsbetweennowand2019(Moody’s,2014).Thedegreeofcompliancevariesmuchmoreforbaseliii’snewliquidityrequirements.AnFSbsurveyindicatesthatArgentina,brazil,indonesiaandMexicoarebehindothercountriessuchasChinaandSouthAfrica intheirextentofcompliance(FSb,2014a).AccordingtoarecentassessmentbyFitch(2015),smallerbanksinMexicowillstruggletomeettheliquiditycoverage

ratio,andwillfaceanevenbiggerchallengewhenthenetstablefundingratiorequirementsareeventuallyadoptedbytheircountry’sregulators.

DevelopingcountriesotherthantheG20mem-bersappeartobefacingamuchgreaterchallengeinmeetingbaselrequirements.Acriticalchallengeisthelevelofcomplexityofbaselrules,particularlythenewrulesunderbaseliii,whichnotonlyrequiresophisticatedtechnicalcapabilitiesfortheirimple-mentationbutarealsoresourceintensive(HaldaneandMadouros, 2012). FSAP reports on countriesfromdifferentdevelopingregionsindicateagenerallackofcompliancewithbaselstandardsduetocriti-calcapacitygaps.Theseinclude,overall,insufficientandpoorlytrainedstaffwhoalsolacktheexperienceto perform regulatory and supervisory functions

Table 4.1

bASEL IMPLEMENTATION IN DEVELOPING AND TRANSITION ECONOMIES

Basel II Basel III

Total economies surveyed

Capital requirements (Standardized

approach)

Capital requirements

(Internal ratings based approach)

Leverage ratio

Liquidity coverage

ratio

(Per cent) (Per cent)

Region (whole sample)

Africa 30 27 10 13 13East, South and South-East Asia 17 82 59 47 29Latin America and the Caribbean 21 38 23 14 24Transition economies from Europe and Asia 11 73 9 18 18West Asia 9 100 33 33 33

Region (excluding BCBS members)

Africa 29 23 7 10 10East, South and South-East Asia 11 27 13 0 7Latin America and the Caribbean 18 16 7 7 3Transition economies from Europe and Asia 10 23 3 7 3West Asia 7 23 3 3 3

Source: UNCTAD secretariat calculations, based on BIS, 2014 and 2015.Note: The data cover the following economies, by region: Africa: Angola, Benin, Botswana, Burkina Faso, Côte d’Ivoire, Democratic

Republic of the Congo, Egypt, the Gambia, Ghana, Guinea, Guinea-Bissau, Kenya, Lesotho, Liberia, Madagascar, Malawi, Mali, Morocco, Mozambique, Namibia, Niger, Nigeria, Senegal, South Africa, Togo, Tunisia, Uganda, United Republic of Tanzania, Zambia and Zimbabwe; East, South and South-East Asia: Bangladesh, Bhutan, China, Hong kong (China), India, Indonesia, Malaysia, Mauritius, Nepal, Pakistan, the Philippines, Republic of korea, Singapore, Sri Lanka, Taiwan, Province of China, Thailand and Viet Nam; Latin America and the Caribbean: Argentina, Belize, Bolivia (Plurinational State of), Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Guatemala, Guyana, Haiti, Honduras, Jamaica, Mexico, Panama, Paraguay, Peru, Trinidad and Tobago, Uruguay; Transition economies from Europe and Asia: Albania, Armenia, Belarus, Bosnia and Herzegovina, Georgia, Kyrgyzstan, Montenegro, Republic of Moldova, the Russian Federation, Serbia and the former Yugoslav Republic of Macedonia; and West Asia: Bahrain, Jordan, Kuwait, Lebanon, Oman, Qatar, Saudi Arabia, Turkey, United Arab Emirates (countries in bold are members of the Basel Committee).


satisfactorily.Thesegapsbecomeevenmorecriti-calwithrespecttotheverycomplexbaseliiirules.

Thereareothersignificantconcernsrelatedtotheimplementationofbaseliii.TheadoptionoftheNSFR,which aims at reducing thematuritymis-matchesbetweenbanks’assetsandfundingsources,may have adverse consequences for developingcountries,asbanksinthoseeconomiesaremainlyfundedthrough(short-term)deposits.Assuch,therequirementforastrictmatchbetweenmaturitiesofassetsandliabilitiesmayreducebanks’abilitiestosupplylong-termcredit.Anotherchallengehastodowith the implementationofcountercyclicalcapitalbuffers.economiesatearlystagesoffinancialdevel-opmentmayexperiencerapidcreditgrowthwhichtriggers the buffermechanism, even though theremaynotbeabuild-upofsystemicrisks(DrehmannandTsatsaronis,2014).

Amoregeneralconcernisthatbaselregulationshaveincreasinglyfocused(withoutmuchsuccess)onanarrowviewoffinancialstabilityat theexpenseof regulations geared towardsthe realization of growth andequity objectives.Relianceonrisk-weightingforcapitaldeter-mination,whether through thestandardized approach or themorecomplexmethods,islikelyto result in credit rationing tosectors thatneedsupportfromadevelopmentperspective.ThebaselguidelinesforcreditriskmeasurementmayincreasethecapitalrequirementsforfinancingSMes(whicharegenerallyviewedaspresentinghigherrisks)andforlong-termprojects,whilemakinglendingcheapertolargerfirms,includinginternationalcompaniesthatareusuallyawardedhigherratingsbyexternalCRAs.

Therefore, it seems that, despite developingcountries’ greater representation on internationalforums,thereformsundertakenfollowingtheglobalfinancialcrisisdonotseemtoaddressanumberoftheirconcerns.Thefocusonnarrowlydefinedpru-dential reformsmaybe inadequate for preventingfuturecrises.Theyarealsocomplexanddifficulttoimplementinmanydevelopingcountries,andindeed,theirimplementationmayposeobstaclestoeconomicdevelopment.

4. Some attempts to ring-fence banking operations

in parallel to the adoption of the regulatoryreformscoordinatedbytheFSbattheinternationallevel,manydevelopedcountriesdraftednewnationallegislationtoaddresssystemicrisksintheirfinancialsystems.of all the reformproposals triggeredbythefinancialcrisis,themostfar-reachingarethosecontainingprovisionsto“ring-fence”financialactivi-ties,whichgobeyondtheprudentialapproachofthebaselframework.

Thebasicargumentforring-fencingisthatinsu-latingdepositors’assets fromriskybankactivitieswouldlimittheprobabilityofabankrunincaseofinsolvencyresultingfrom“casino”investmentdeci-sions.Suchseparationwouldalsofacilitateresolutionofabankinggroupindifficultyandwouldreducethelikelihoodorthenecessityofgovernmentinter-ventiontosavebanksthathaverunintotroubleasaresultoftheirhigh-risktradingactivities.Ahistorical

precedent is theUnitedStatesGlassSteagallAct,whichpro-hibitedcommercialbankswithprivileged deposit insurancefromengaginginmarketactivi-ties,whileexcludinginvestmentbanksfromacceptingdeposits.Thatreform,whichwaspartoftheNewDealof1933,regulatedthe functioning of theUnitedStates financial system for aperiodofover65yearsuntilthe

FinancialServicesModernizationActof1999liftedrestrictionsonbanks.

TheUnited States did not reintroduce deepbankreorganizationmeasuresafterthe2008−2009financialcrisis,butoptedinsteadforarulerestrictingsomeoftheactivitiesofbanks.Amongitsvariousprovisions, theDodd-FrankWall Street ReformandConsumerProtectionActof2010includedtheVolckerRule,whichprohibitstwotypesofactivities.First,abankingentityunderUnitedStatesjurisdic-tionisnotallowedtoengageinproprietarytrading.Thismeansthatbankscannotbuyorsellsecuritiesfortheirownaccount.15Second,theRuleprohibitsbanksfromsponsoring,acquiringorretaininganownershipinterestinhedgefundsandprivateequityfunds.

Despite developing countries’ greater representation on international forums, the reforms undertaken seem to neglect a number of their concerns.


inlate2013,theUnitedKingdomintroducedlegislationonbankingreformbasedontheso-calledVickersReport.Unlike in theUnited States, thereformdid not focus on prohibiting banks’ riskyactivitiesbutonring-fencingdeposit-takinginstitu-tions.Assuch,itwasdecidedthatretailbankinghadtobesetapartfrominvestmentbankinginaseparatelycapital-izedsubsidiary.Theaimsofthereformwere to help insulatedomestic retail banks fromexternal financial shocks andfacilitateresolutionoftroubledbanks should the need arise(FSb,2014b).Therecommen-dationsoftheVickersReportwerearesponsetotheworryingfact,fromtheUnitedKingdomperspective,thattheinternationalexposureofthatcountry’sbank-ingsectorwasmanytimeslargerthanthedomesticeconomymeasuredbyitsGDP.oneoftheaimsofring-fencingwas to protect domestically orientedbankingfromwhatevermighthappeninthegloballyorientedactivities(Wolf,2014).16Thering-fencingappliedonlytolargefinancialgroupsholdingcoredepositsofover£25billion.

TheeuropeanCommission (eC) also exam-ined the possibility of structural reform of theeuropeanUnion’sfinancial system.based on therecommendations of itsHigh-levelexpertGrouponbankStructuralReform(theso-calledliikanenCommission),theeCsubmitteddraftregulations,acorepropos-alofwhichwasthatproprietarytradingandotherhigh-risktrad-ingactivitiesshouldbeassignedaseparatelegalentityfromtherest of a bank’s businesses. ifthe reform is enacted, itwillbe restricted to banks holdingassetslargerthan30billioneuros,anditwillapplynotonlytodeposit-takingbanks,butalsototheirpar-entcompaniesandsubsidiaries.FranceandGermanyhavealreadyintroducedrulespartiallybasedontherecommendationsoftheliikanenCommission.

ThestructuralmeasuresproposedbytheUnitedStates,theUnitedKingdomandtheeuropeanUnionaim to lower the probability of bank failure andits systemic implications by reducing the risk fordepositsassociatedwithbanks’interconnectedness(Viñalsetal.,2013).Apossiblewaytorestructure

thefinancialsectorwouldbetoestablishafirewallbetweenbankstakingdepositsandthoseengagedinbroker-dealeractivities.However,ring-fencinginitia-tives–justlikeproposalstoraiseminimumcapitalrequirements–facestrongresistancefromthebank-ingindustrylobby.indeed,noneofthering-fencing

rules discussed above is fullyinplaceyet.implementationoftheVolckerRule in theUnitedStateshasbeenpostponedsev-eraltimes,andafurtherdelayto21July2016setbyUnitedStatesregulators is being considered.intheUnitedKingdom,regula-tors expect to finalize rules in

2016,withbanksfullycomplyingby2019,butthereisconsiderableresistancefromthesector.

itisstillunclearwhetherthesemeasureswillbeabletoinhibitfurtherexpansionoflargebanksandmakeiteasierforgovernmentauthoritiestomanageorcontrolthem.Pressuresfromsomefinancialactorshavemadetheproposedregulationsmuchmorecom-plexthantheyneededtobe.exceptions,loosedefi-nitions and supervisory judgements couldweakentheoutcomesof thereforms.in theUnitedStates,thereareimportantexceptionstotheprohibitionofproprietarytradingandothertradingactivities.Theexceptionsincludepermissiontoengageinhedgingactivitiestomitigaterisks,proprietarytradinginvolv-ingUnited StatesGovernment debt instruments

andmarket-making.The lackof a precise definition of pro-prietary trading enables banksto determine for themselveswhichtradingactivitiesareper-mitted,andwhicharenot.Anddespite reforms inFrance andGermany, the intention seemstobetomaintaintheuniversal

bankingmodel, althoughnational supervisorswillhavethediscretiontoseparatecertainactivitiesfromcorebanking,butonlywhentheyjudgeafinancialinstitution’ssolvencytobeunderthreat.

Therefore,itremainstobeseentowhatextentthevariousregulatoryandstructuralreformmeasureswill be sufficiently effective in reducing the com-plexityandinterconnectednessoflargebankssoastomakethemsafer,andwhethertheywilldiscour-agethesebanksfrombecomingevenlarger,orhelpreverselong-termtrendsinbankingconcentration.

Ring-fencing bank activities would limit the probability of a bank run in case of losses from “casino” investment decisions…

… and facilitate the resolu-tion of a banking group in difficulty, thus reducing the likelihood of expensive gov-ernment bailouts.


1. The emergence and principal features of the shadow banking system

After the 2008–2009 global financial crisis,largebanksreducedsomeoftheirlendingactivitiestorepairtheirbalancesheetsandadapttotighterregula-tions.Asaresult,banks’credittotheprivatesectorindevelopedcountrieshaswitnessedadownwardtrend.

Despite this movement, total global debtexpandedby$57 trillionbetween2007and2014,which increased the ratio of global debt toGDPby 17 percentage points to 286 per cent ofGDP(McKinsey,2015).Thegrowthinborrowingoccurredprincipallyoutsidethetraditionalregulatedbankingsystem.indevelopedcountries,formsofnon-bankfinance,suchascorporatebondsandcreditissuedbynon-bankinstitutions,havesoaredsincetheglobalcrisis.Meanwhile,bankmanagershavecontinuedtomoveactivitiesofftheirbalancesheets,afterpack-agingtheloansintosecuritiestosellinthemarkets.Althoughsecuritizationhasdeclinedinimportancecomparedwiththepre-crisisperiod,itremainssig-nificant:in2014,32percentofthestockofhouseholddebt (mainlymortgages and credit card loans) indevelopedcountrieswassecuritized,against36percentin2007(McKinsey,2015).

The shift in credit intermediation from thebankingtothenon-bankingsectorreflectsthelargerroleoftheassetmanagementindustry(iMF,2015).Thisindustryiscomposedofinstitutionalinvestors,including insurers, and investment funds such ashedgefundsandmutualfunds,aswellasoff-balancesheet entities such as special purpose entities, allofwhichbuyandsellsecuritiesandotherfinancialassets.17Financingviacapitalmarketsinvolvesboth“directfinance”mechanisms,inwhichinvestorsbearallthecreditrisk,andtheso-calledshadowbanking

system.bothcomplement(butalsocompetewith)traditional banking, and are alternative sources offundingforrealeconomicactivity.Shadowbanking,however,posesanumberofthreatstofinancialstabil-ity,asitperformsthesamefunctionsastraditionalbankingwithoutappropriateregulation.

in the shadow banking system credit inter-mediation takes placewith less transparency thantraditional banking.Agents in that system takedeposits (just as banks do) or accept deposit-likeinvestments,extendcreditandperformmaturityandliquiditytransformation,oftenrelyingonleveragingtechniques to increase profitability.They convertshort-term liabilities, such as deposit-like sharesinmoneymarketmutual funds (MMMFs), into awiderangeoflong-termassets−fromgovernmentsecurities to bonds issued bymeans of complexsecuritization techniques. Financial companiesperforming bank-like intermediation face fewerrestrictionsontheirsizeandleverage,butlackaccessto explicit liquidity guarantees.Thismakes theshadowbankingsysteminherentlyfragile.

Theroleoftheshadowbankingsysteminthe2008financial crisis iswell known, andhas beendocumented and analysed in previousUNCTADreports(e.g.TDRs 2009 and 2011).TheG20andtheFSbhaveidentifiedanumberofproblemswiththatsystem,whichcontributetoglobalfinancialfragility.However,notnearlyenoughhasbeendoneintermsofregulationoftheshadowbankingsystem.Clearly,moreambitiousreformsareneeded.

Shadowbankingistheoutcomeofderegulationofthefinancialsystemoverthepastfourdecades.Thismarket-basedsystemdevelopedmainlyintheso-calledAnglo-Saxoncountries,andthenexpandedtomostoftheothercountries,includingthedevel-oping ones. in the process, institutional investors(includinginsurancecompanies,pensionfundsand

C. The rise of the shadow banking system


mutualfunds)becamemajorparticipantsinglobalfinancialmarkets,andthesizeoftheirassetsundermanagement rapidly caught upwith those of thebanking system. Subsequently,most institutionsturned to specialist assetmanagers to help theminvest,whichdrovegrowthinequitymarketsdur-ingthe1980sandinthehedgefundsindustryinthe1990s. Direct investment byinstitutionalinvestorsprovideda stable and reliable sourceoffunding for borrowers and theopportunity for investors tohold a diversified portfolio offinancialassets.

Thedevelopmentofinno-vative forms ofmarket inter-mediation allowedmany assetmanagers(suchashedgefunds)andbroker-dealers(oftenbelongingtofinancialcon-glomerates) to expand investments by leveragingwithin thefinancial systemandfundingassetpur-chaseswith theirdebt.Asa significantproportionofthedebtissuedbyintermediarieswasshortterm,thefinancial companiesperformedmaturity trans-formation.inthetraditionalbankingsystem,inter-mediationbetweendepositorsandborrowersoccursinasingleentity.bycontrast,thecreditintermedia-tionprocessperformedbytheshadowbankingsys-temcaninvolvenotjustone,butawebofspecial-izedfinancialinstitutionsthatchannelfundingfromlenderstoinvestorsthroughmultiplemarket-basedtransactionsandlendingvehicles.

Asimpleexamplefacilitatesanunderstandingofthebasicfunctioningoftheshadowbankingsys-tem.ThetypicallenderinthecreditintermediationchainisahouseholdinvestingitscashholdingsinsharesofanMMMFinsearchofahigheryieldthantheonetypicallyofferedbyadepositinacommercialbank.18Thelendermayalsobeatreasurerofalargecompanyseekingtoinvestavailablecashinadiffer-entformthanbankdeposits,whichinmostcountriesarenot insuredfor largesums.Thefinalborrowerintheshadowbankingsystemisanyentityissuingsecurities(i.e.agovernmentorprivatecorporation)tofunditsexpendituresorinvestments.itcanalsobeahouseholdifitsloansordebts(e.g.mortgageorcreditcarddebt)arepackagedintosecuritiesbybanksorspecializedfinancialinstitutions.Securitizedbonds(includingstructuredsecurities)areinfactakeycomponentoftheshadowbankingsystem.The

cash resources fromMMMFs and companies areinvestedinshort-termdebtsecurities(i.e.commer-cialpaperandgovernmentbillsoranydebtabouttoreachmaturity)andinshort-term(oftenoneday)repurchaseagreements(repos).Reposareaformofsecured lendingbackedby collateral, so that theyseem safer than non-insured bank deposits (see

box4.1).investmentsinbillsorcommercialpaperdonotcarrysignificantmaturityrisk,astheshort-term funding ismatchedwith short-term investments.but the liquid resources pro-vided through reposoften endupbeingusedbytheborrowerfor the outright purchase of along-term security or anotherasset in such away that thesystemperformsmaturitytrans-

formation, similar towhat banks do but in a lesstransparentway.Thebroker-dealermayindeedusethefundsitraisesthroughrepostopurchasehigh-qualitysecurities,whichitthenusesascollateralforthetransaction.19Hedgefundsaretypicallyengagedinreposandotherkindsofshort-termborrowingforleveragedinvesting.

Shadowbankingisgrowingstronglyindevel-oping economies, although the steps involved inthechainsofcreditintermediationtendtobesim-pler.Thatsaid,itcanstillposesystemicrisks,bothdirectly,asitsimportanceinthetotalfinancialsystemgrows,andindirectlythroughitsinterlinkageswiththeregulatedbankingsystem(Ghoshetal.,2012).

2. How big is shadow banking?

Theperimeterof theshadowbankingsystemanditsoverallsizearecurrentlyunderdebate.TheFSb, engaged since 2011 in a global project tomonitor andmeasure shadowbanking, originallydefineditas“creditintermediationactivitiesinvolv-ing entities outside the regular banking system”(FSb, 2014c). Following this definition, the sizeofthesystemisdeterminedbythevolumeoftotalfinancialassetsofnon-bankfinancialintermediaries,excludinginsurancecompanies,pensionfundsandpublicfinancial institutions (which are regulated).Many judged this definition as being too broad.

In the shadow banking system, credit intermediation takes place with less trans-parency and regulation and higher leverage than tradi-tional banking.


Box 4.1

REPOS: ThE CORE TRANSACTION OF ThE ShADOw bANkING SySTEM

A repurchase agreement (or repo) is an acquisition of funds through the sale of securities,with asimultaneousagreementbythesellertorepurchasethem−orsubstantiallysimilarones−atalaterdate,oftenovernight.Theborrowerpaysinterestataratenegotiatedwiththelender,andretainstheriskandreturnonthatcollateral,sothattheroleofthesecurityinvolvedinthetransactionisonlytoprovidecollateraltothelender.Reposarethereforeameansofsecuredlendingofshort-termfunds.inpractice,however,asizeableportionofthefundsusedremainsinreposforrelativelylongperiods,asthedailycontractsarerolledover.inthatsense,reposareadeposit-likefundingsourcefortheborrower.Meanwhile,theownersofthefundscantreatthemvirtuallyasdemanddeposits,astheyhavereadyaccesstothecash,shouldtheneedarise,bynotrenewingorrollingovertherepo.

Reposareattractivetocorporatetreasurersandotherholdersoflargecashbalancesbecausetheycanearnasecuredmarketrateofreturnuntiltheyareusedforpayments.inaddition,reposmayseemsaferthanbankdeposits,whicharenotprotectedbydepositinsuranceforlargeamounts.Repos,alongwithcommercialpaper,arealsoatypicalinvestmentproductforMMMFs,whoseshareholdersarealsoultimatelendersintheshadowbankingsystem.

Theborrowerintherepotransactionmayusethecashtofinancealongpositionintheassetinvolvedinthecollateral,inamountsandatpricesthatreflectthesecurityprovidedtothelender(iCMA,2015).broker-dealersalsofrequentlyarrangereverserepos inorder toborrowthesecuritieswithwhich toengageinarepo;bymatchingarepoandareverserepotransaction,theymayprofitbythedifferenceininterestrates.Dealersalsousereverserepostoacquiresecuritiestomakeashortsale.

Theadvantageforborrowersthroughrepos,includingcommercialbanksandbroker-dealers,isthattheyarenotrequiredtoholdreservesagainstfundsobtainedthroughtherepos.aAnotheradvantageistheflexibilityinrecordingthesetransactionsinthebooks,atleastforfirmsoperatingintheUnitedStatesundertheGenerallyAcceptedAccountingPrinciples(GAAP).Forinstance,somelenderschoosetorecordtheirownershipofsecuritiesratherthantheirownershipofrepos,whichmaybeconsideredabetterriskandthuslesscostlyintermsofcapitalrequirements.Forborrowers,assetssoldinreposmayberemoved(temporarily)fromthebalancesheets,therebydisguisingthetrueleveloftheleverage(iCMA,2015).b

Thebankruptcy“safeharbour”forreposhasbeenasignificantfactorcontributingtothegrowthofshadowbanking(GortonandMetrick,2009).intheUnitedStates,reposareexemptfromcorebankruptcyrulessuchastheautomaticstayondebtcollectionunderChapter11oftheUnitedStatesbankruptcyCode.UnderNewYorklaw(themainjurisdictionforUnitedStatesrepos),apartytoarepocontractisallowedtounilaterallyenforcetheterminationprovisionsoftheagreementasaresultofabankruptcyfilingbytheotherpartybysellingthecollateraltorecoverthedeposit.Withoutthisprotection,apartytoarepocontractwouldbeadebtorinbankruptcyproceedings(GortonandMetrick,2009).cineurope,therepotransferslegaltitletocollateralfromthesellertothebuyerbymeansofanoutrightsale.Thereforeinmajorfinancialcentres,forlargedepositors,reposcanactassubstitutesforinsureddemanddeposits.

it encompasses non-leveraged activities by fundmanagersthatadministerinvestmentsonbehalfoftheirclients,whobeargainsandlossesdirectly,sothatthereisnointermediationperse.inresponsetothis,theFSbstartedreportingonanarrowermeasure,filteringoutnon-bankfinancialactivitiesthathavenodirectconnectionwithcreditintermediation(e.g.the

transactionsofnon-leveragedequityfunds)orthatareprudentiallyconsolidatedintobankinggroups(e.g.securitizedproductsheldbybanksandassetsfromthebroker-dealeractivitiesoftheuniversalbanks).

TheiMFhasproposedmeasuringthevolumeof the “non-core” liabilities of both banks and


An interesting featureof repos is that thecollateralpostedbyaclient to itsbrokermaybeusedascollateralalsoby thebroker for itsownpurposeswithanunrelated thirdparty.Thesamecollateralcanthereforesupportmultipletransactions.indeed,brokersmayrehypothecatetheassetsreceivedascollateral,forinstancefromahedgefund,togainaccesstothemoneytheylendtoitscustomer.Theclientthatborrowedthemoney(thehedgefund)canuseitsincreasedassetsforanewrepotransaction.Thedealerusesthesecuritytoraisemorefunds,andsoon,ad infinitum (SinghandAitken,2010).Unlimitedleveragehaspracticalconstraints.Marketparticipantstendtoapplyhaircuts(apercentagediscount)tothecollateralinarepoinordertocalculateitspurchaseprice.Applyinghaircutsisequivalenttoaskingforanovercollateralization.Theadjustmentisintendedtotakeaccountoftheunexpectedlossesthatonepartytotherepotrademightfaceinbuying(orselling)thesecuritiesiftheotherpartydefaults.Haircutslimittheleverage.Forinstance,ahedgefundfinancingitsassetpositionthrougharepo(andusingthepurchasedassetascollateral)willneedtobuypartofitspositionwithitsownresources.Aninfinitemultiplierwouldalsocomeupagainstthecreditlimitsimposedbyfinancialinstitutionsontheircounterpartiesand,ifapplied,againstlimitsduetoregulatoryconstraints.

AccordingtotheinternationalCapitalMarketAssociation(iCMA),therearelargerepomarketsineurope,theUnitedStates,latinAmericaandJapan,aswellasrapidlyemerging(althoughstillrelativelysmall)repomarketsinChinaandanumberofAfricancountries.outstandingrepocontractsintheeuropeanrepomarkettotalledanestimated5.5trillioneurosinDecember2014,butthisestimateisnotcomprehensiveasitonlyincludesthemostactiveparticipantsintheeuropeanrepomarket(iCMA,2015).TheFederalReservebankofNewYorkreportedthattheoutstandingrepobusinessofprimarydealers(whomayaccountforasmuchas90percentoftheUnitedStatesmarket)amountedtoalmost$5trillionin2014.TheiCMACentreatReadingUniversityhassuggestedthat,althoughtheglobalmarketforreposhascontractedsince2007,itmayhaveamountedto15trillioneurosin2012.GortonandMetrick(2009)suggestanamountuptothreetimeslargerfortheUnitedStates.

a iftheyarebanks,theleverageratiomayapply,dependingontheaccountingrulesofthejurisdictionswheretheyarebased.

b ThefirmsoftenuseloopholesspecifictotheUnitedStatesGAAP.inordertoensurethatthebalancesheetmakesclearwhichassetshavebeensoldinrepos,theinternationalFinancialReportingStandards(iFRS)requiresthatsecuritiesagainstarepobereclassifiedfrom“investments”to“collateral”andbalancedbya“collateralizedborrowing”liability.

c According toMorrisonet al. (2014), evidence shows that exemptions from thebankruptcyCode’snormaloperationforreposdistortthecapitalstructuredecisionsoffinancialfirmsbysubsidizingshort-termfinancingattheexpenseofother,saferdebtchannels,includinglongertermfinancing.Whenfinancialfirmsprefervolatileshort-termdebttomorestablelong-termdebt,they(andmarketsgenerally)aremorelikelytoexperiencea“run”intheeventofamarketshock,suchasthedownturninhousingpriceswitnessedduringtheglobalfinancialcrisis.

Box 4.1 (concluded)

non-bankfinancialinstitutionstoestimatethesizeoftheshadowbankingsystem(iMF,2014).Non-coreliabilities are all the funding sources of financialfirms thatdiffer frombankdeposits.According tothis definition,which includes all non-traditionalfinancial intermediation, securitization is alsopartof shadow banking, regardless ofwhether it is

conducted directly onbalance sheet by a bankorindirectly through a special purpose entity (SPe).TheiMFhasalsosuggestedanarrowermeasureofshadowbankingwhichexcludesinterbankdebt.

based on theFSb’s broadmeasure, shadowbanking activity has expanded significantly since


2002, particularly in developed economies, and,notably,itcontinuedrisingafterthefinancialcrisis.itsoverallsizeintermsofassetswasanestimated$75.2trillion,oraboutonefourthoftotalfinancialintermediationworldwideattheendof2013,asharprisefrom$67trillionin2011and$71trillionin2012.ThelargestshadowbankingsystemsarelocatedintheUnitedStates,theeurozoneandtheUnitedKingdom(chart4.2),butshadowbankingintermediationhasbeenalsoexpandinginafewdevelopingcountriessuchasChina(seebox4.2).

other forms of shadowbanking exhibited asimilar growth trend until 2007, but the patternchangedafterthecrisis,whenitstagnatedordeclined,accordingtoiMFmeasures.20Themainreasonforthis,bothintheUnitedStatesandintheeurozone,wassluggishactivityamongissuersofasset-backedsecuritiesandafallincommercialbankdebtissu-ance.MMMFs’shares,whichalsoshrankafterthecrisis, furthercontributedto thedropin totalnon-coreliabilities.incontrast,FSbestimatespointtoapick-upofshadowbankingactivityafterthemild

Chart 4.2

SIzE OF SHADOw BANkINg By DIFFERENT MEASuRES, 2001–2013(Trillions of dollars)

Source: Harutyunyan et al., 2015; and FSB, 2014c.

0

5

10

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20

25

30

2001 2003 2005 2007 2009 2011 2013

A. Eurozone

0

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2001 2003 2005 2007 2009 2011 2013

B. Japan

0

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2001 2003 2005 2007 2009 2011 2013

C. United Kingdom

0

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2001 2003 2005 2007 2009 2011 2013

D. United States

FSB (broad measure) FSB (narrow measure) IMF (broad measure) IMF (narrow measure)


Box 4.2

ShADOw bANkING IN ChINA

inChina, theriseofashadowbankingsystemisquiterecent,asbankshavecompletelydominatedthecreditsystemsincethemarketreformsofthelate1970s.evenasrecentlyastheendof2008,bankloansrepresentedalmost90percentofoutstandingcreditinChina(elliottetal.,2015;elliottandYan,2013).Reformsinthecountry’sfinanceandbankingsectorsoverthe1990sand2000s(okazaki,2007;Kruger,2013)resultedingreatersophisticationoffinancialinstrumentsandalsomadeitmorepossibletoavoidregulatorycontrols.

ShadowlendinginChinatakesplacethroughawiderangeofentitiesinvolvingfivemainsourcesoffinancing:wealthmanagementproducts,entrustedloans,trustloans,financingcompaniesandinformalloans.Manyshadowbankingactivitiesarespecificallydesignedtocircumventbankingregulations,andcanthereforebeinterpretedasformsofinternalregulatoryarbitrage(ChandrasekharandGhosh,2015).Forexample,despitecapsonlendingvolumesofbanksandlimitsonloanstopotentiallyriskyborrowers(suchaslocalgovernmentfinancingvehicles,realestatedevelopers,coalminersandshipbuilders),thoseloansactuallycontinuedtoincrease,becausetheywereroutedthroughshadowlending.

Wealthmanagementproducts(WMPs)provideareturnbasedontheperformanceoftheunderlyingassets(asingleloanorapoolofloans),typicallyhigherthanbankdepositratestowhichmonetaryauthoritiesapplycaps,therebyenablinginterestrateliberalization“bystealth”(Kruger,2013).Theyarepromotedaslow-riskinstruments,andasignificantnumberofthemofferguaranteedreturns(iMF,2014).entrustedloansare inter-company loans inwhichonefirmservesas theultimate lender and records the loanassetonitsbalancesheet,whilebanksactasintermediariesandcollectfees.Fundsofentrustedloanstypicallyflowintoassetssuchaspropertyandstocks,andtheyareapotentialrisktofinancialstabilitysincetheygenerateanewroundofcreditandincreaseleverage.Thereareotherchannelsthroughwhichnon-financialfirmsoffercredittooneanother,suchascorporatediscountingofbankacceptancebills,whichcanalsobeusedtoaddtoleverage(eliottetal.,2015).

Guaranteecompanies,originallycreatedtohelpSMesobtainaccesstobankloans,chargeprospectiveborrowersafee,andinexchangeserveasaguarantortoabank,pledgingtopayforanylossesintheeventofadefault.ineffect,the“creditguarantee”companysellsinsurancetothebankforariskyloan,withtheborrowerhavingtotakeonthepremium.likeanyinsurancescheme,thisarrangementmayberiskyiftherisksarecorrelatedbetweenborrowers.Finally,otherformsofintermediationconsistofinformallendingbyindividualmoneylenders(suchaspawnshopsandkerblenders)tohouseholdsandsmallbusinesses.

independentestimatesoftheextentofshadowbankinginChinavarywildlyfromalowof8−22percentofGDPtoahighofasmuchas70percentofGDPin2013(ChandrasekharandGhosh,2015).AccordingtotheiMF(2014),socialfinancingthroughshadowbankinghadrisento35percentofGDPbyearly2014,anditisexpandingattwicetherateofbankcredits.ThevalueoftotalassetsofWMPsaccountedfor25percentofGDP,havinggrownby50percentsinceearly2013,andthreefoldsinceearly2011.Underthebroadestdefinitionsofshadowbanking,China’sshadowbankingsectorremainsmuchsmallerrelativetothesizeofitsGDPthanthoseoftheUnitedStates(150percent),theUnitedKingdom(378percent)andmanycountriesoftheeurozone.

Aspartoftheireffortstocurbtherisksassociatedwiththeinformalfinancialsector,theChineseauthoritiesintroducedinsuranceforbankdepositsofupto500,000renminbiperdepositorperbankinApril2015,coveringbothindividualsandbusinesses.Thisshouldmakethedistinctionbetweenbankdepositsandunprotectedwealthmanagementproductsclearer,butthereisstilllikelytobeintensepoliticalpressuretostepinandrescueunprotectedinvestorswhensuchschemesfail(eiU,2015).officialshavefrequentlystatedthattheGovernmentwillnotbackshadowbankingtransactionsundertakenbybanks,althoughtheissueiscomplex,sincebankownershipinChinaisheldbytheGovernmentintheformofshares.


dropin2008,reflectinggrowthinthevolumesinter-mediatedbyinvestmentfundsandpositivevaluationeffectsfollowingtherecoveryofassetpricesfromtheirlowvaluesin2008−2009.

However,thesizeofshadowbankingtendstobegrosslyunderestimated,asmostmeasuresexcludetheshadowbankingentitiesdomiciledinmanyoffshorefinancialcentres,ortaxhavens.TheFSbrecognizedthatincorporatingdatafromtheseoffshorecentres,whicharenon-FSbmemberjurisdictions,wouldhelpfillgapsinthecurrentglobalmonitoringexercise.Suchgapsmaybelarge,asfinancialentitiesmovesizeableportionsoftheirshadowactivitiestooffshorecentrestoavoidregulationsintheirhomecountries.

3. Risks associated with shadow banking

The specialization of each institution partici-patinginthechainofintermediationoftheshadowbanking system allows borrowers and lenders toavoidcreditspreadsandotherfeeschargedbytra-ditionalbanks.inthatsense,shadowbankingmaybringefficiencygainsfromspecializationwithlowercostsforclientsandhealthycompetitionforbanks.it has been argued that securitization enables themobilization of illiquid assets,thus broadening the range ofpotentiallenders,andthatstruc-turedfinancetechniquescanbeused to tailor the distributionofriskandreturns tobetterfitthe needs of ultimate inves-tors (iMF, 2014). However,activitiesthatresemblebanking,particularlybytakingdeposits,create specific financial risks.Unlikebanks,towhichauthori-tiesapplycapitalrequirementsandotherrules,thetransactionsintheshadowbankingsystemarenotregulatedandlackexplicitpublicsectorcreditguaranteesoraccesstocentralbankliquiditybackstops.Problemsintheintermediationchaincanthereforetriggerasystemiccrisisinthewholefinancialsystem.

Since the2008crisis, various featuresof theshadowbanking systemhave been highlighted ashighlyproblematicforfinancialstability.Aleading

concern is the quality of somefinancial productstradedinthatsystem.Someoftheloanspackagedintosecuritiestobesoldinthemarket(i.e.asset-backedsecurities)haveoftenbeenpoorlyunderwritten,withissuersnotrecordingtherisksintheirbalancesheets,andinsteadtransferringthemtothebuyers(Covalet al., 2008).21As the 2008 crisis has shown, the“originateanddistributemodel”carriesmoralhazard.banksarelikelytobemorecarefulinevaluatingriskwhentheyplantokeepaloanontheirbooks,whilesecuritizationmayleadtoweakenedlendingstand-ardsandadeteriorationofcreditquality.Aparticularconcernrelatestocomplexsecuritizationstructures(e.g.collateralizeddebtobligations),forwhichrisksareparticularlydifficulttoassess.

A second concern, directly related tomacro-economicstability,isthatshadowbankingishighlyprocyclical.Whenassetprices arehigh, thevalueofthecollateralforreposincreases,enablingmoreleverage.Shadowbankingthereforecontributes toassetpricebubbles(Pozsaretal.,2013),andalsotoacreditcrunchwhenafinancialcyclecomestoanabruptend.Sometypesofcollateralusedfortransac-tionsmayevenbecomeunacceptableduringperiodsofturmoil.

indeed,athirdconcernisthatshadowbankingisparticularlypronetorisksofclients’suddenand

massivewithdrawals of fundsoriginating frommarket-basedtransactions instead of froma run on deposits. indeed, thepanicof2007−2008originatedinasecuritizedbankrun(areporun)drivenbythewithdrawalofrepurchaseagreements(GortonandMetrick,2009).Uncertaintyastotherealvalueoftheassetsservingascollateralledtomas-sive redemptions on the repomarket.

A fourth concern relates to contagion effectsfromrunsontheshadowbankingsystemtotherestofthefinancialsystem.onemechanismofcontagionisthroughassetprices.intheeventofarunontheshadowbankingsystem,massivesalesofassetsmayhave repercussions forpricesoffinancialand realassets and a direct impact on themark-to-marketvaluationofsecuritiesinthebooksofthetraditionalbanks.Asecondmechanismofcontagionrelatesto

Shadow banking may bring efficiency gains from specialization, with lower costs for clients and healthy competition for banks, but many of its features are highly problematic for financial stability.


thefactthatbanksalsofundactivitiesinthewhole-salemarket,where illiquidity caused by shadowbankingactivitiesmayinducethebankstoengageinrapiddeleveraging.Thiscanleadtoafurtherfallinpricesandcreatenegativefeedbackloops.Suchspillovers also take place internationally. Finally,sincebanksandinsurancecompaniesprovideshadowentitieswith back-up liquidity lines and implicitguaranteestospecialpurposevehicles,incidentsinshadowbankingmaydirectlyaffecttraditionalinter-mediaries(Greeneandbroomfield,2014).

4. Insufficientreforms

itissurprisingthat,sofar,regulatoryreformshave paid relatively little attention to themanyentities and activities of shadowbanking. indeed,focusingmainlyonreforming the regulatedfinan-cialsectormayevenbeinducingalargemigrationof banking activities towards the shadowbankingsystem,ashintedearlier(seealsoiMF,2014).

AttheG20SeoulSummitinNovember2010,leaders requested theFSb to develop recommen-dations to strengthen oversight and regulation ofshadowbanking activities.22 in response, theFSbdevelopedaframeworkforconductingannualmoni-toringexercisestoidentifyentitiesandactivitiesincredit intermediation and assessglobal trends andrisksposedby theshadowbankingsystem.23FSbrecommendationstoimprovethemarketinfrastruc-tureandtheresilienceofinstitutionsarenowunderconsiderationbynationalauthorities.Theyaddressanumberofidentifiedconcerns,includingaheavyrelianceonshort-termwholesalefundingforsomeintermediaries,weakenedlendingstandardsduetosomesecuritizedassetsandstructuredproducts,anda general lackof transparency that hides growingamounts of leverage andmaturitymismatches, aswellastheultimatebeareroftheassociatedrisks.

The proposed reforms cover four areas (dis-cussed below), and some countries have alreadyadoptednewregulations.

(i) in order tomitigate risks in banks’ interac-tionswith shadowbankingentities, therearerecommendations to set risk-sensitive capitalrequirementsforbanks’investmentsinequity

fundsandaproposedsupervisoryframeworkformeasuring and controlling banks’ largeexposures,includingtoshadowbankingactivi-ties.CountriesthataremembersofthebaselCommitteehaveagreedtofullyimplementtheframeworkby2019.

(ii) inordertolimitmassiveandsuddenredemp-tions, the followingmeasures are proposed:limittheuseofconstantnetassetvaluetoallowthesharepricesofthosefundstofluctuateinlinewiththemarketvalueofthefunds’assets,impose capital buffers, require redemptionrestrictions,establishliquidityandmaturityport-foliorequirements,andrequirestresstesting.24

(iii)in order to improve transparency in securiti-zation, it is recommended that risk retentionrequirements be included for entities spon-soring securities, and that banks and otherfinancialsponsorsofsecuritizationtransactionsberequiredtoretainpartoftheloansontheirbooks.ThelatterwasapprovedbytheUnitedStatesin2014.

(iv)Regarding repoagreements, inoctober2014theFSbpublishedaregulatoryframeworkforsecurities financing transactions in order tolimitexcessiveleverageaswellasmaturityandliquiditymismatchedexposures.itconsistsofminimumqualitativestandardsformethodolo-giesusedbymarketparticipants thatprovidesecuritiesfinancingtocalculatehaircutsonthecollateralreceived,andnumericalhaircutfloorsthatwillapplytonon-centrallyclearedrepos,inwhichfinancingagainstcollateralotherthangovernment securities is provided to entitiesotherthanbanksandbroker-dealers.

Additionalworkonothershadowbankingenti-tiesisalsounderwaywithintheFSbinordertolisttheentitiesthatcouldbecovered,maptheexistingregulatoryandsupervisoryregimesinplace,identifygapsinthoseregimes,andsuggestadditionalpru-dentialmeasuresforthoseentities,wherenecessary.

Theaimoftheseregulatoryreformproposalsistotransformshadowbankingintoaresilientmarket-based system of financing.However,while theyaddressparticularrisks,theproposedactionsappearto be insufficient to dealwith the system’s inher-entsystemicrisks.Amajorchallengetoregulatory


reform of the shadow banking system is how toensureappropriateoversightandminimizeriskstofinancial stabilitywhile not inhibiting sustainablenon-bankfinancing conduits that donot pose sig-nificant risks, particularlywhere shadowbankingfillsagap.

inthecaseofsecuritization,thebalancesheetcapitalretentionrequirementsoflessthan5percentseemarbitraryandsmall;investorsmaystillconfuseMMMFswithdepositsandbesusceptibletopanics.Forrepos,theproposedhaircutsareonlyforbilateraltransactions, leaving open the possibility of largerehypothecation(andleverage)incentrallyclearedmarkets.TheFSbevendroppedtheminimumhair-cutsrequirementonreposwithgovernmentbondsthatithadinitiallysuggestedtomakerepo-supportedleveragemoreexpensive(FSb,2012).inaddition,theFSbmonitoringexerciseisnotcomprehensive,asdatacollectionfromoffshorefinancialcentresislacking.

Measures suchasafinancial transactions tax(FTT)applied to repos,whichwouldsignificantlyreduceleverageintheshadowbankingsystem,are

missingfromtheFSbreformagenda,andhavebeenfiercelyopposedbymostmarketparticipants(includ-ingcentralbanks).25otherambitiousreformsmoreconsistentwithamarket-basedapproachhavebeensuggested,buttheyhavenotreceivedproperconsid-eration.Forinstance,GortonandMetrick(2009)haveproposedprinciplesforregulationofshadowbankingentitiesbasedonthepremisethatanykindofbankingshouldbebroughtundertheregulatoryumbrella.onthispremise,regulatorswouldhavetoprovidestrictguidelinesonwhatkindsofcollateralmaybeusedforreposandonminimumhaircuts(tolimitleverag-ingandreducerehypothecation).Totallyunregulatedreposmaystillbeauthorized,butauthoritieswouldhavetomakeitclearthatthebuyeroftherepowillnotreceivespecialbankruptcyprotection.

Tosumup,despitesomemovestowardstight-ening rules relating to specific activities, shadowbanking remains largely unregulated, probablybecauseofthepressuretoavoidimpactsonthepriceoffinancialservicesorontheprofitabilityoffinancialinstitutions.Thismeansthatthesystemicrisksaris-ingfromtheverynatureofshadowbankingcouldcontinuetoposeathreattoglobalfinancialstability.

D. Other important issues in financial regulation

Theglobalfinancialcrisisraisedunprecedentedconcernsaboutthegovernanceoffinancialinstitu-tionsandthelackoftransparencyofinformationinfinancialmarkets.Thelistofdistortedincentivesattherootof thecrisis is long,butat thetopof thatlistare the roleofcredit ratings in regulations forriskassessment(discussedbelow)and,ofparticularimportancefordevelopingcountries,theabsenceofinternationalmacroprudential regulations to tamespeculativeinternationalcapitalmovements.inthiscontext,foreignbankswithbranchesandsubsidiar-iesindevelopingcountriesareimportantchannelsfortransmittingglobalfinancialspilloverstotheseeconomies, and therefore pose specific regulatorychallenges.

1. Credit rating agencies: The need for more than a code of conduct

Creditratingagencies(CRAs)areafundamen-talinstitutionoftoday’sfinancialmarkets.26byratinglargecorporateborrowers,sovereignbonds,munici-palbonds,collateralizeddebtobligationsandotherfinancial instruments,CRAs provide prospectiveinvestorswithguidanceontheborrower’screditwor-thiness.Theroleofratingsistoprovideinvestorswithinformationandopinionsonwhetherabondissuermayrenegeonitscommitments.Theratingservicescatertobothnon-specialistbondholders(e.g.thegen-eralpublicandsmallfinancialfirms)andspecialist


investors(i.e.financialintermediariessuchasbanks,insurancecompaniesandpensionfunds).Theyhelptheformerbyprovidingthenecessaryinformationtoassessthecreditworthinessofborrowers;andtheycan help the latter obtain information concerningunfamiliarbondmarketsornewlendingactivities.

TheactivitiesofCRAs,asexpressedthroughnewsaboutratings,haveanimpactonassetalloca-tion, as ratings contribute to the determinationoftheinterestrate−orprice−theborrowermustpayforobtainingfinancing. Reliance on creditratingshasincreasedovertimewiththedevelopmentoffinan-cial markets and the use ofratingsinregulations,standardsandinvestmentguidelines,bothatthenationalandinternationallevels,asevidencedbytheirfre-quentreferencestoCRAs’ratings.Theyconstituteakeycomponentofregulatoryriskmeasurement,andcanbeused to determine capital requirements forbankinginstitutions.Theyalsoinfluencedecisionsonwhether the ratedassets canbeusedas collat-eral,anddeterminebenchmarksforassetmanagers’strategies.Thebaseliicapitaladequacyframeworkallowsbankstoconsiderexternalcreditassessmentsoftheborrower‒orthespecificsecuritiesissuedbytheborrower‒forthedeterminationofriskweightfor the banks’ exposures.Another example is thereliance bymany central banks onCRAs’ assess-ments of thefinancial instruments they accept foropenmarketoperations,bothascollateral and foroutrightpurchase.

However,thewideuseofCRAratingshasnowcometoberecognizedasathreattofinancialstabilityandasourceofsystemicrisk.

The2008−2009globalfinancialcrisisservedasareminderofanumberofseriousproblemsintheratingsindustry.itbecameclearthatmanyratings,such as those relating to subprime collateralizeddebt obligations and other securities − includingfromgovernments−hadbeen artificially inflated.Thiswasrelatedtothebusinessmodelsoftheratingagencies,which contain serious conflicts of inter-est:essentially,ratingagenciesarepaidbytheveryissuerswhosesecuritiestheyarerating.27overratingdebts and underestimating the default risk allowstheissuertoattractinvestors.“buy-side”investors

mayhave incentives to accept inflated ratings, asthisincreasestheirflexibilityinmakinginvestmentdecisions and reduces the amountof capital tobemaintained against their investments.This alsoexplainswhyinstitutionsbuyoverpricedsecurities(Calomiris,2009).

The overreliance onCRAs’ assessments ofstructured financial products contributed signifi-cantly to the 2007−2008 subprime crisis, aswell

documented, for instance bythe iMF (2010).However, thedebate considerably pre-datesthe 2008 global crisis, whenCRAsclearlyperformedbadlyinmeasuring the risk of sub-primedebts.Theywereheavilycriticized for their role in the1997Asianfinancialcrisisandthe 2001 dot-com bubble for

havingbeenslowtoanticipatethesecrises,andthenforhavingabruptlydowngradedthedebtors.

Downgrades in ratings have triggered largesell-offs of securities as a consequence ofmarketparticipantsadjustingtoregulationsandinvestmentpolicies (“cliffeffects”).Thehighvolatility in theeuropean sovereign debtmarket in 2011 after anumberofratingdowngradesisanexampleofthelinkagesbetweendowngradesandthepricesofdebtinstruments.Conversely, ratingupgrades can con-tributetomechanisticpurchasesofassetsin“goodtimes”,which can fuelfinancial bubbles.AnothermajorconcernwithCRAsisrelatedtodeficienciesin their credit assessment process.An additionalsourceofunease is thatCRAs’ ratings,whicharebasedonsubjectivecriteriaratherthanoneconomicfundamentalsfordeterminingsovereigndebtsustain-ability,exerciseastronginfluenceonmarkets,issuersofsecuritiesandpolicymakers(seealsobox4.3).

overrelianceonratingshasthereforebecomeaconcernforinternationalregulatoryauthorities.TheFSbpublisheditsPrinciples for Reducing Reliance on Credit Rating Agency Ratings in2010,whichwereendorsedbytheG20.ThegoaloftheprinciplesistoreducetheuseofCRAs,andtoprovideincentivesfor improving independentcredit riskassessmentsandduediligencecapabilities.Memberjurisdictionshavecommittedtopresentingatimelineandspecificactions for implementing changes in the regula-tions.Atthesametime,theFSbhassuggestedthat

In assessing sovereign debt sustainability, credit rating agencies follow ideological prejudices rather than economic fundamentals.


Box 4.3

bIASING INFLUENCES ON CRAs’ RATINGS OF SOVEREIGN DEbT

Ratingsofsovereigndebtorsinvolveconsiderablejudgementaboutcountryfactors,includingeconomicprospects,politicalriskandthestructuralfeaturesoftheeconomy.CRAsprovidelittleguidanceastohowtheyassignrelativeweightstoeachfactor,thoughtheydoprovideinformationonwhatvariablestheyconsiderindeterminingsovereignratings.broadlyspeaking,theeconomicvariablesaimatmeasuringthecreditworthinessofaneconomybyassessingthecountry’sexternalpositionanditsabilitytoserviceitsexternalobligations,aswellastheinfluenceofexternaldevelopments.CRAs’assessmentsappear tobebasedonabiasagainstmostkindsofgovernment intervention. inaddition,theyoftenassociatelabourmarket“rigidities”withoutputunderperformance,andahighdegreeofcentralbankindependenceashavingapositiveimpactondebtsustainability(Krugman,2013).

Sovereignratingsofthethreemajorratingagenciesarestronglycorrelated(seetable),possiblysignallingaverylowdegreeofcompetitionintheCRAmarket.Atthesametime,theirratingsaresignificantlycorrelatedwith indicators thatmeasure theextent towhich theeconomicenvironment is“business-friendly”,regardlessofwhatimpactthismighthaveondebtdynamics.

Aneconometricmodel,basedonapooledsampleoftheaveragevalueofthe“bigThree’s”sovereignratings of 51 developing countries for the period2005−2015,indicatesacloselinearfit(R2of44percent) between those ratings and the followingvariables estimated by theHeritage Foundation:“labour freedom”, “fiscal freedom”, “businessfreedom” and “financial freedom” (chart 4b.1A).However,thesevariablesappeartohavebarelyanyrelationtothecountries’fundamentals,whichwoulddeterminetheirabilitytoservicetheirsovereigndebt.

For instance, “financial freedom” is considereda measure of independence from governmentcontrol and “interference” in thefinancial sector.Consequently, an ideal banking and financeenvironmentisbelievedtobeonewherethereisaminimumlevelofgovernmentintervention,creditisallocatedonmarketterms,andthegovernmentdoes

notownfinancialinstitutions.Also,insuchanenvironment,banksarefreetoextendcredit,acceptdepositsandconductoperationsinforeigncurrencies,andforeignfinancialinstitutionscanoperatefreelyandaretreatedinthesamewayasdomesticinstitutions.The“labourfreedom”indexisaquantitativemeasurethatconsidersvariousaspectsofthelegalandregulatoryframeworkofacountry’slabourmarket,includingregulationsconcerningminimumwagesand layoffs, severance requirements,measurable regulatoryrestraintsonhiringandhoursworked.“Fiscalfreedom”isameasureofthetaxburdenimposedbythegovernment,basedonacombinationofthetopmarginaltaxratesonindividualandcorporateincomes,andthetotaltaxburdenasapercentageofGDP.Finally,“businessfreedom”referstotheabilitytostart,operateandclosedownabusiness(HeritageFoundation,2015).

bycontrast,theeconometricestimatesshowamuchweakercorrelation(R2of16percent)whenCRAs’ratingsareregressedonthefourmostrelevantvariablesusedinthestandardmacroeconomicliteraturetoassessdebtdynamics(chart4b.1b).Thosevariablesare:theleveloftheprimarybudgetsurplus,thegovernment-debt-to-GDPratio,economicgrowthandthecurrentaccountbalance.

TheseestimatesshowthatCRAs’sovereignratingsarebasedmuchmoreonsubjectiveassessmentsandprejudices(forinstance,thatgovernmentinterventionreducesgrowthandefficiency)thanonthe“fundamental”variablesrelatedtodebtsustainability.

ThereisastrongriskthatalternativeapproachestocreditassessmentmightreproducethesameflawsoftheunderlyingCRAmodels.indeed,otherCRAs,includingtheChinesefirm,Dagong,haveproducedjudgementssimilartothoseofthe“bigThree”:Moody’s,StandardandPoor’sandFitch(chart4b.2).Thissuggestseitherthatotherparticipantsbasetheirjudgmentsonsimilarmodels,orthatthe“bigThree”aremarketmakersintheratingsindustry.Assuch,thereistheaddedconcernthatinternalcreditriskassessmentsmadebyriskdepartmentsofinvestors’institutionsalsodeliverratingswithsimilarflaws.

CORRELATION bETwEEN SOVEREIGN RATINGS OF ThE “bIG ThREE”, jANUARy 1990 TO MARCh 2015

Fitch Moody’s

Standard and

Poor’s

Fitch 1 0.955 0.970Moody’s 1 0.956Standard and Poor’s 1

Source: UNCTAD secretariat calculations, based on Thomson Reuters Eikon database.

Note: The sample includes 129 issuers. The number of observations are: Fitch vs. Moody’s: 17,908; Fitch vs. Standard and Poor’s: 18,317; and Moody’s vs. Standard and Poor’s: 23,258.


Chart 4B.1

SOVEREIGN RATINGS OF DEVELOPING COUNTRIES, ACTUAL AND FITTED VALUES, 2005–2015

(Average of the ratings of the “Big Three”)

Source: UNCTAD secretariat calculations, based on Bloomberg and Heritage Foundation databases; and IMF, World Economic Outlook, 2015.

Note: Countries covered are those for which data were available from all the selected CRAs. Country ratings have been converted into numerical order, ranging from 0 (defaulted security) to 20 (highest rating). For chart A, fitted values correspond to the best possible prediction of the average rating based on a linear regression against four variables taken from the Heritage Foundation Index of Economic Freedom: “labour freedom”, “fiscal freedom”, “business freedom” and “financial freedom”. For chart B, fitted values are the best possible prediction of the average rating based on a linear regression against four macroeconomic variables: budgetary primary surplus, ratio of public debt to GDP, current account balance and GDP growth rate.

Chart 4B.2

CORRELATION bETwEEN COUNTRy RATINGS OF SELECTED CRAs

Source: UNCTAD secretariat calculations, based on Standard and Poor’s; and Dagong. Note: Country ratings have been converted into numerical order, ranging from 0 (defaulted security) to 20 (highest rating). Countries

covered are those for which data were available from both CRAs. Data are as on July 2015.

Act

ual r

atin

gs

Fitted values predicted by ideological variables

45O Correlation = 0.66

Act

ual r

atin

gs

Fitted values predicted by fundamental variables

45O Correlation = 0.40

A. Actual vs. fitted values predicted by ideological variables

B. Actual vs. fitted values predicted by fundamental variables

02468

101214161820

0 2 4 6 8 10 12 14 16 18 2002468

101214161820

0 2 4 6 8 10 12 14 16 18 20

R² = 0.8643

0

2

4

6

8

10

12

14

16

18

20

0 2 4 6 8 10 12 14 16 18 20

Dag

ong

Glo

bal C

redi

t Rat

ings

Standard and Poor’s

Box 4.3 (concluded)


referencestoCRAratingsberemovedorreplacedoncealternativeprovisionsinlawsandregulationshavebeenidentifiedandcanbesafelyimplemented.

Regulatoryeffortshavealso sought toestab-lish a codeof conduct forCRAs.A report by theinternationalorganizationofSecuritiesCommissions(ioSCo,2015) focusesonthequalityandintegrityoftheratingprocess,avoidanceofconflictsofinter-est, transparency, timeliness of ratings disclosuresandconfidentialinformation.Regionalandnationalregulatorshavethediscretiontoadoptmorestrin-gent regulations forCRAs. For example, in theUnitedStates, theDodd-FrankAct has attemptedto address problems relating toCRA ratings byrequiringthatbanksnolongerusethoseratingsintheirriskassessmentsforthepurposeofdetermin-ing capital requirements.RecenteuropeanUnionregulationsrequiregreaterdisclosureofinformationonstructuredfinancialproductsandonthefeesthatCRAs charge their clients (eC, 2013 and 2014).Nevertheless, the pace of regulatory change hasbeenslow.

Creditratingagenciesarestillofrelevanceforthefinancialsector,despitetheirdisastrouslyinac-curate ratings assessments prior tomajor crises.Followingwidespread recognition that the con-centrationof the sector in the three biggest inter-nationalCRAs has created anuncompetitiveenvironment,andthatitisthereforenecessarytoreduce theirpower, therehavebeen different suggestions formore substantial changes.TheoeCDhighlightedtheneedtocurb conflicts of interest, anissuethatCRAscouldaddress,forinstancebymovingfroman“issuer pays” to a “subscriberpays”businessmodel(oeCD,2009).butthisnewmodelwould require some kind of public sectorinvolvementtoavoidfree-riderissues.othershavesuggestedmoreradicalmeasures,suchascompletelyeliminating the use of ratings for regulatory pur-poses(Portes,2008),ortransformingtheCRAsintopublicinstitutions,sincetheyprovideapublicgood(AgliettaandRigot,2009).Also,bankscouldpayfeestoapublicentitythatassignsratersforgradingsecurities.Alternatively,bankscouldreverttowhathas historically been one of theirmost importanttasks,namelyassessingthecreditworthinessofthe

potentialborrowersandtheeconomicviabilityoftheprojectstheyintendtofinance(Schumpeter,1939;brender,1980).

Policymakersshouldbemadeawareofthecur-rentflawsintheconstructionofriskmeasures,andaconceptualframeworkforanalternativeapproachshould be designed.Alternative sources of creditassessmentshouldavoidrepeatingthesamekindsofmistakesthatledCRAstounderestimaterisk.

2. The negative impacts of speculative internationalcapitalflows

Anothermajorconcernaboutthenewfinancialreformsisthevirtualabsenceofconcreteinternationalregulationstotamespeculative,short-terminterna-tionalcapitalflows.overthepastfewdecades,manycountrieshaveexperiencedstrongmacroeconomicandfinancialvolatilityasaresultofcapitalinflowsdrivingexchangeratesawayfromfundamentalsfol-lowedbycapitalreversalstriggeredbychangesininternationalmonetaryconditions(TDRs 2009and2011).Someproposalsthatcouldhaveaddressedthisissue,suchasaninternationalagreementforataxoninternationalcurrency transactions,havebeendis-

cussedatapolicylevel,buthavereceivedlittlepoliticalsupportfromdevelopedcountriessofar.

Risks related to interna-tionalcapitalflowsarenotonlyaconcernfordevelopedcountriesand for the larger developingeconomies that are viewed asemergingmarkets.increasingly,manymiddle-andlow-income

countriesthatareconsidered“frontiermarkets”mayalsohavetocopewithvolatilecapitalflows.Theirgrowing reliance on international capitalmarketsto raisefinance,whichwasmadepossibleby lowinternational interest rates and investors’ growingappetiteforrisk,makesthemvulnerabletosuddenreversalsofforeigncapital.itwassuchreversalsthattriggeredseveralfinancialcrisesinlargedevelopingcountriesinthelate1990s.

Capital accountmanagement to regulate theamount and composition of foreign capital flows

Financial reforms have not included concrete international regulation to tame speculative cross-border capital flows.


canhelpmitigatesuchrisks.brazil,indonesiaandtheRepublic ofKorea, amongothers, have intro-ducedmeasurestoreduceexcessivecapitalinflowswithreasonabledegreesofsuccess.Further,notalldevelopingcountrieshavepromotedrapidinterna-tionalfinancialintegration.Whilesomehavesoughttoenhancetheirintegrationintotheglobalfinancialsystem, favoured the installation of foreignbanksandstartedissuingcommercialexternaldebt,othershavepreferreddelayingsuchintegration.ethiopia,for instance, has not resorted to easily availableforeigncapital,andhasimposedrestrictionsonthecapitalaccountinitsbalanceofpayments.Foreignbanks are not allowed to operate in that country.Thisstrategydoesnotimpedethedevelopmentofadomesticfinancialsystemtoservetheneedsofthereal economybecause of a strategy for long-termcreditprovisionthroughitsdevelopmentbank,alongwith considerable funding fromprivate domesticbanks(Alemu,2014).Asaresult,itsfinancialsystemisabletochannelfundstoprioritysectors,includingmanufacturingandinfrastructure.

3. Foreign bank presence in developing countries

Arelatedissuehasbeenthegrowingcommer-cialpresenceofforeign-ownedbanksindevelopingcountries.This trend started in the late1990sandcontinuedwith full force in the newmillenniumuntiltheglobalfinancialcrisis.initially,inthe1990s,privatizationofState-ownedbankswasanimportantfactorinthegrowingpresenceofforeignbanksindevelopingcountries.Subsequently,jointownershipwithlocalprivatebanksandfullyownedsubsidiariesgainedimportance.

Accordingtoonerecentestimate, thecurrentshareofforeignbanksinthetotalnumberofbanksaverages24percentinoeCDcountriesandaround40percentindevelopingcountries(ClaessensandvanHoren,2014).between1995and2009,foreignbanksasapercentageofthetotalnumberofbanksdoubled insuchcountries,anda largemajorityofthemare fromdeveloped economies (buch et al.,2014).Moreover,thisproportionistypicallyhigherinpoorerandsmallercountriesthaninthemajordevel-opingeconomies, reaching in somecases100percent.Amongthemajordevelopingcountries,there

areconsiderablevariationsinforeignbankpresence.TheRepublicofKorea,whichhadnoforeignbanksbefore it joined theoeCD in 1996, has seen thefastestincreaseintheirpresenceoverthepasttwodecades, though theirshare in the totalnumberofbanksinthecountryisstilllowerthantheaverageforothermajordevelopingcountries.China,indiaandSouthAfrica also have a lower foreign bankpresence thanother developing countries, both intermsofthenumberofbanksandtheirsharesintotalbankingassets.

inadditiontojointownershipwithlocalpart-ners,foreignbankshaveenteredhostcountriesbyestablishingbranchofficesorfullsubsidiaries, theformerbeingthemoretypicalpatterninAsianandAfricancountries,andthe latter inlatinAmerica.Foreignbranches take the formofunincorporatedbanksorbankofficeslocatedinaforeigncountry.Theyareintegralpartsoftheirparentbank,andnotindependentlegalentitieswithseparateaccountsandcapitalbases.Theycannotincurliabilitiesandownassets in theirown right; their liabilities representrealclaimsontheirparentbank.Theyprovideglob-ally fundeddomestic credits.by contrast, foreignsubsidiaries are stand-alone legal entities createdunderthelawofthehostcountry.Theyhaveseparateaccountsandcapitalbasesfromthoseoftheirparentcompanyandarefinanciallyindependent.Theyhaveto complywith thehost country’s regulationsandsupervision,andarecoveredbythehostcountry’sdepositinsuranceschemes.

Muchhasbeenwrittenon thepros andconsofforeignbanksindevelopingcountries.onebodyofliteraturesuggeststhatforeignbanksmaybringefficiencygains, improve competitiveness, reduceintermediationcostsandgeneratepositivespilloversto local banks in developing countries, and alsoenhancetheirresiliencetoexternalfinancialshocks.

However,theirpresencemightalsocreatechal-lenges.Forexample,foreignbanksoftencherry-pickthebestcreditorsanddepositors,leavingsmallerandmarginalcustomers,includingSMes,tobeservedbylocalbanks.Moreover,foreignbankstendtofocusmoreonlucrativeactivitieswheretheyhaveacom-petitiveedge,notablyintradefinancing,anareainwhichtheyenjoyacostadvantageoverlocalbanksin being able to confirm letters of credit throughtheirheadoffices; and their internationalfinancialintermediation,ratherthandomesticintermediation,


often attracts the best customers in need of suchservices.Theyarealsobetterable tobenefit fromregulatoryarbitragebyshiftingoperationsbackandforth between the home and host countries.Theycaneasilyavoidthecostoflegalreservesbymov-inglargedepositstooffshoreaccounts,whichalsoenablesthemtoofferhigherinterestrates.Sincelocalbankscannoteasilyavoidthesecosts,theymayfacecompetitivedisadvantages.

Moreover, foreign banksintermediate between interna-tional financial markets anddomesticborrowersmuchmoreeasily than local banks, fund-inglocal lendingfromabroad,including through their parentbanks.Duringtherecentsurgein capital flows to developingcountries, foreign banks have been extensivelyengaged in intermediations resemblingcarry-tradeoperations,benefitingfromlargeinterest-ratearbi-tragemarginsbetweenreserve-issuingcountriesanddevelopingcountriesaswellascurrencyapprecia-tionsinthelatter,asdiscussedinchaptersiiandiii.

Since the global financial crisis, it has beenincreasingly recognized that the large presence offoreign banks in developing countries could haveimplicationsforfinancialvolatility(Fiechteretal.,2011). indeed,becauseof theirclose internationallinkages,foreignbanksinsuchcountriesactascon-duitsofexpansionaryandcontractionary impulsesfromglobalfinancial cycles, particularlywith thegrowing liberalization of international financialflows.Thus,whenglobal liquidity and risk appe-titearefavourable,foreignbankscancontributetothe build-upof excessive credit; andwhenglobalfinancialconditionsbecometight, thesebankscanintensifytheirdestabilizinganddeflationaryimpactonhostcountries,transmittingcreditcrunchesfromhometohostcountries,ratherthaninsulatingdomes-ticcreditmarketsfrominternationalfinancialshocks.Theshiftof internationalbanks fromcross-bordertolocallendingimpliesthatattimesofstressinthehomecountry,deleveragingbyparentbankscouldresultincreditcontractioninhostcountries.

ThiswasseeninAsiaduringtheeurozonecrisis,wherelendingbylocalsubsidiariesandbrancheswasasubstantialpartofoveralleuropeanbankclaims(AiyarandJain-Chandra,2012;HeandMcCauley,

2013). Several other studies have also found thatforeignsubsidiariescutlendingmorethandomesti-callyownedbanksduringtheglobalcrisis(ClaessensandvanHoren,2014;ChenandWu,2014).Thiswasparticularlytruewheretheyfundedalargeproportionoftheirlendingfromabroadratherthanfromlocaldeposits(CetorelliandGoldberg,2011).Attheheightofthecrisisin2008,inbrazilandChina,thegrowthofforeignbankcreditlaggedbehindthatofdomestic

banks,and“foreignbanksinone[emergingmarketeconomy]…withdrewearlierthandomesticbanksfromtheinterbankmar-ket”(biS,2010b).DuringboththeAsiancrisisin1997andthecrisis in developed countriesin 2008, foreign bankswereslower thandomesticbanks toadjusttheirlendingtochanges

inhost-countrymonetarypolicy,therebyimpairingitseffectiveness(JeonandWu,2013and2014).

Recentexperiencesuggeststhatlocalsubsidi-ariesofforeign-ownedinternationalbanksmaynotactasstabilizersofinterestrateshockstodevelop-ingeconomies’localbondmarkets.Duringthebondmarketcollapsein2008,ratherthanincreasingtheirexposuretooffsettheimpactoftheexitofforeigninvestors, thesebanks joined them, reducing theirholdingsoflocalgovernmentbondsandscalingbacktheirmarket-makingactivity(Turner,2012).

otherchallengesarisingfromthepresenceofforeignbanksrelatetothestructureofthebankingsystem.Suchbanksmaybesystemicallyimportantinthehostcountry,eventhoughtheiractivitiesmayrepresent only a small proportion of their globalbusiness.This creates regulatory difficulties forhostsupervisors,especiallywhenthereisalackofhome-hostcountrycoordinationinthesupervisionofthetransnationalbanks’activities.Thisbecomesaparticularlyseriousissuewhenhostsupervisorshavetodealwithresolutionproblemsarisingfromcross-borderfailures.oneresponsetothesechallengeshasbeentoensurethatforeignbanksareeffectivelyregu-latedbythehost-country’ssupervisors.Anotherisforthehostcountrytorequireforeignbanks’branchestoholdtheirowncapital,assomecountrieshavedone.othermeasures(introducedinMexico,forexample)imposehighercapitalrequirementsonforeignbanksortransferlimitso

trade and development report, 2015financial regulatory reform after the crisis 89 in the post-crisis...

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