As economies in developing Asia are quite diverse in population, demographics, and per capita GDP, it is no surprise that they vary widely in the size, structure, and complexity of their banking systems. They all have a common need, however, for supervision and regulation to keep their banking systems safe and sound. This means ensuring that their inevitable problems are manageable and that their bank failures, when unavoidable, are not large or systemic. Meanwhile, banks must remain able to meet credit needs.
By Asian Development Bank
As economies in developing Asia are quite
diverse in population, demographics, and per capita GDP, it is no surprise that
they vary widely in the size, structure, and complexity of their banking
systems. They all have a common need, however, for supervision and regulation
to keep their banking systems safe and sound. This means ensuring that their
inevitable problems are manageable and that their bank failures, when
unavoidable, are not large or systemic. Meanwhile, banks must remain able to
meet credit needs.
Image Attribute : Shanghai Skyline, China / Source: Wikimedia Commons
Given the huge
role of banks in Asia and the crippling effect of banking crises on growth,
regulatory authorities’ first line of defense against financial stability is
naturally the sound prudential supervision and regulation of these institutions
(Table 2.4.1). In addition, regulatory authorities in the region need to follow
guidelines set by Basel III core principles for bank regulation, which
were recently introduced to strengthen global regulatory standards in the
aftermath of the global financial crisis.
Southeast Asia
in particular has unique regulatory and supervisory challenges arising from
ongoing regional financial integration. The past 20 years have seen the
emergence and expansion of many large banking conglomerates throughout the
region. Some of these conglomerates operate banks that are systemically
important in more than one economy. Conglomerate interconnectedness poses
potential contagion risk—the possibility that problems arising in one affiliate
can spread to other affiliates through various mechanisms such as inter-company
transactions.
Bank
supervisory authorities in jurisdictions where conglomerates operate subsidiary
banks need to ensure timely and effective two-way communication and
information-sharing with their foreign counterparts. Coordination among
supervisors enables better understanding of the risks and financial soundness
of the conglomerate parent and its bank and other subsidiaries, as well as the
risks posed by transactions between affiliated organizations.
Basel III in Developing Asia
Those who set
international standards, such as the Financial Stability Board and the Basel
Committee on Banking Supervision, pursue reform agendas intended to reduce the
risks of bank failure and to mitigate the cost of failures and thereby preserve
public confidence in the banking system when they occur. In particular, Asian
banks are now confronted with Basel III and the tightening of the Basel
Committee’s core principles for bank supervision agreed in 2011–2012 in
response to the global financial crisis. That crisis resulted partly from a
serious failure of bank regulation in the advanced economies. Basel III
presents voluntary regulatory standards on bank capital adequacy, stress
testing, and market liquidity due to be implemented by March 2019. The initial
Basel principles were agreed in 1988 and revised in 2004 (Basel II).
Table 2.4.2 compares Basel II and Basel III, and Table 2.4.3 outlines the
implementation table for Basel III.
Adherence to
the more stringent Basel III standards will further strengthen Asian banks’
balance sheets and mitigate their vulnerability to shocks. The regulatory
framework reduces opportunities for regulatory arbitrage and harmonizes
regulatory standards. However, the region must ensure that tightened
regulations do not seriously compromise banks’ capacity to fulfill their core
function of channeling credit to households and firms for investment and
production.
Banks in Asia
appear sound today even under the new stricter standards of Basel III thanks to
earlier efforts to strengthen their capital base, reduce nonperforming loans,
and bolster loan loss provisions, especially after the Asian financial crisis
of 1997–1998. However, another reason is that the region’s financial markets
are underdeveloped and not as exposed to sophisticated instruments as their
counterparts in more financially advanced economies. Bank capital, for
instance, is mostly held as simple paid-in capital and retained earnings.
Although they
preserve financial stability and improve transparency among banks, the new,
stringent regulatory standards raise the cost of financial intermediation and
limit the availability of bank credit. In upper-middle-income countries,
relatively scant and expensive bank finance will encourage the development of
bond markets, as their economies already have a core bond market and a growing
institutional investor base such as insurance companies. The tight leverage
ratio under Basel III will likely limit the supply of bank finance, as banks in
these countries often stretch their balance sheets. Moreover, capital
requirements will likely constrain the provision of bank finance for SMEs
unless efforts are made to enhance secured and unsecured lending and promote
nonbank finance for SMEs.
For
lower-middle-income countries, the challenges that Basel III pose are
somewhat different and more challenging. The new financial standards,
particularly liquidity requirements, are likely to constrain the generation of
medium- to long-term bank finance because financial systems are heavily dominated
by banks. While solvency policies are designed to encourage very long-term
investment by insurance companies, insurance industries are often too small in
these economies to compensate for the loss of medium- to long-term finance from
banks. Therefore, in addition to developing a base of long-term institutional
investors such as insurance companies and pension funds, regulators must, in
the meantime, induce banks to meet their capital adequacy requirements by
expanding their capital, not cutting back their lending.
Lessons from
the global financial crisis
According to
Zamorski and Lee (forthcoming), international experience during the global
financial crisis provides some valuable lessons for Asian bank regulators.
Above all, the crisis underlined that sound and effective bank regulation is
vital to financial stability. The crisis reflected the failure of regulatory
authorities to keep pace with financial innovation. The sobering lesson for
Asia and the rest of the developing world is that even financially advanced
economies are susceptible to risks from lax regulation and reckless lending.
Assessments of
the global financial crisis of 2008–2009 invariably point to ineffective
finance regulation and supervision as the main reasons for the onset of the
crisis and its severity. In particular, lapses in banking regulation
contributed significantly to the outbreak. Regulators allowed banks to operate
with excessive leverage and failed to curtail risky lending, primarily
mortgages to subprime homebuyers who were inadequately screened for
creditworthiness.
Bank
supervision had been weak by any measure. Supervisors did not conduct regular
onsite bank inspections or examinations of sufficient depth. They did not
properly implement risk-based supervision, and they failed to identify
shortcomings in banks’ risk-management methods, governance structures, and risk
cultures.
Instead,
overemphasis on banks’ historic operating results and static financial
conditions in assessing risk failed to reveal potential vulnerabilities.
Meanwhile, offsite surveillance systems relied too heavily on banks’
self-reported data to effectively monitor risk. Regulators failed to understand
the risk and policy implications of new bank products and services and changing
business models, or to establish effective lines of communication with their
counterparts in other economies, through which they could have shared vital
information.
Post-crisis
analysis by the International Monetary Fund, Financial Stability Board, and
Basel Committee on Banking Supervision identify additional aspects of bank
supervision that could have helped avoid the global financial crisis:
(i) Adequately
monitoring and controlling macro-prudential risk, and not just individual bank
risk, as a buildup of such vulnerabilities could hit a number of institutions
simultaneously, posing systemic risk;
(ii) Conducting
comprehensive stress testing of the banking system and other economic sectors,
taking into account highly risky scenarios even if they seemed unlikely;
(iii) Paying
attention to concentrations of risk and to interdependencies, including cross-border
risks; and
(iv) Considering
risks in the shadow banking industry or cross-sector risks posed by non-bank
financial intermediaries.
The last major
episode of cross-border financial instability and banking crisis in developing
Asia occurred more than 17 years ago. To extend this impressive record of
relative calm, bank supervisory authorities in the region need to assess their
supervisory systems, infrastructure, and actual practices. The lessons learned
in the global financial crisis will be useful to this process. If the
assessment reveals that changes, enhancements, or remedial action are needed, a
definitive plan should be crafted and implemented in a timely way.
________________________
Publication Details:
This article is a
part of a chapter for Asian
Development Outlook 2015
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Development Bank
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