Catalog

	Table of Contents
p. -1 of 58 BACK | NEXT Purpose and Structure of the Toolkit Part One: Introduction and Overview Part Two: Preconditions and Infrastructure for Financial Sector Development Part Three: Financial Regulation and Supervision Part Four: Regional Financial Integration Part Five: ADB's Intervention in the Financial Sector Bibliography Glossary and List of Abbreviations Acknowledgements

Financial Sector Legal and Regulatory Toolkit

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Financial Sector Integration

Financial integration is associated with capital mobility, as the extent to which an economy’s financial system is neither shielded nor made distinct from other national and international capital markets. It is the antithesis of the Bretton Woods international financial system that prevailed for almost thirty years following World War II. Such integration is difficult to identify consistently (Gkoutzinis 2006a) because it can often be quantified only by proxy, and since its use was for a long time conflated with other forms of integration. The concept is now more carefully considered than before the 1990s, prior to which views as to what integration might mean were undeveloped and reflected a contemporary view that all aspects of finance were subservient to trade or production. Financial integration emphasizes wholesale activity and examines only secondarily those aspects of retail financial intermediation involving non-professional individuals. Thus legal or customary borders to the trade in retail financial services prevail even in well-integrated regions such as the European Union (Burns and Wells 2008).

Financial integration has also been taken to refer to the extent of correlation in price performance of markets or systems, for example in securities or interest rates (Chi, Li, and Young 2006, Yeyati, Schmukler, and Van Horen 2006). It implies “mobility [of capital] and substitutability among comparable financial assets in terms of yields, maturities and risk in international financial markets” and the expectation of a “full speedy adjustment of asset stocks in response to price changes” (Shepherd 1994, 77–79). Thus true financial integration can be expected to lead to an international convergence of financial asset prices. Financial integration is taken to be distinct from integration in commerce, economic policy, monetary policy or political cooperation, even though such policies may be inter-related, and despite relying upon mechanisms commonly identified as political.

European Financial Integration

Financial integration among EU states is the most developed of any region, the result of objectives set over a long period since the 1950s, in particular to the creation of a single internal market in financial services. Advances in integration have transformed major markets among professional intermediaries, but Europe’s trade in retail financial services remains fragmented and not yet subject to regional competition. This is the result of strong national socio-economic norms that reform and regulation find difficult to overturn, although the introduction of the euro may have induced greater similarities in national retail financial markets (Sørensen and Gutiérrez 2006).

In analyzing European experience, a number of stages can be identified. At the first stage, European officials recognized the potential benefits of and barriers to European financial integration. An influential 1966 study was first to address impediments to the functioning of Europe’s national markets and their openness to foreign borrowers, identifying a home bias towards national governments and other domestic borrowers achieved through regulations on permissible investment by banks and insurers. Further, few companies were listed outside their domiciles.

EU founding treaties provide for free movement of goods, services, workers and capital, and freedom of establishment. In theory, investments may be made without restriction across national borders. However, these initial ideals did not begin to have real meaning until the mid-1980s, the second stage of EU financial integration focusing on harmonization to minimum standards. Today’s level of integration has been achieved in these dimensions partly due to supportive rulings of the European Court of Justice, and markets have become considerably harmonized (Tertak 2006), so that national legislation over most market segments now reflects regionally initiated developments. Member states must adhere to certain precepts so that decisions and legislation passed at the EU level will directly affect those in individual states, while national governments may be liable in damages for failing to implement EU legislation to the detriment of their citizens. In a more technical sense EU experience shows how collaboration and political integration may encourage the adoption of sound principles and practices. The concept of mutual recognition and a system providing a single regulatory license for financial intermediaries now allow EU directives to set minimum norms without hindering competition.

The EU legislative framework for financial markets seeks equivalence among disparate regulatory and legal systems, so that regional initiatives recognize national legal and regulatory regimes (Steil 1996). Rule harmonization proved impossible for many activities and the European Commission adopted principles first outlined in a 1985 white paper (the basis of the second stage of development) (European Commission 1985) that led to the Single European Act. This stipulated a common internal market based upon mutual recognition and common minimum standards, made applicable by EU directives and brought into effect through domestic law. Member states would recognize each other’s law, regulations and authorities, structured along common minimum standards, enabling the freeing of the trade in goods and services without need for prior harmonization (see Steil 1996). The system also uses minimum regional requirements to limit competitive deregulation by state actors and regulatory arbitrage by commercial parties.

National financial regulation in Europe has intensified in recent years due to a combination of the needs of government and pressure from harmonization, access deregulation, and prudential re-regulation inherent in the process of market opening developed under the Maastricht Treaty for unhindered capital mobility. The EU framework for financial services provides minimum standards for financial intermediaries, securities regulation, accounting, company law, and regulation of institutional investors, based on intermediation being unfettered by national borders or restrictions on activity, and an open internal market. However, harmonization leaves the framework incomplete since it augments rather than replaces existing national laws.

Today’s single market is manifested in “passport directives,” by which an authorized intermediary may generally be able to supply services overseas directly or through a foreign branch without maintaining a permanent presence in its target market. The passport’s aim is to promote competition and allow intermediaries to choose how they deliver products or services into any part of the internal market (Fraser and Mortimer-Lee 1993). Passport directives in financial services define the intermediary to which they apply, its activities or market segment, the conditions for initial and continuing authorizations, the division of regulatory responsibility between the home (domicile) state and the host (target) state, and aspects of dealings with non-EU member states (see Fraser and Mortimer-Lee 1993, 93). Such free movement of capital to facilitate European monetary union became effective through the Maastricht Treaty in 1994. This provided an impetus for states to implement prior financial services directives and led to members other than Ireland and the United Kingdom adopting legislation that was foreign to their traditional market practices. The introduction of the single currency in 1999 had a further catalytic effect on the nature of market flows and activity. Following the introduction of the euro, EU members were forced to turn once again to increasing levels of regulatory convergence, a process which is ongoing and represents the third stage of development.

Prior to this degree of political consent, commercial interests may have been a force for financial integration, if only among professional intermediaries. Until the 1990s introduced a high common level of regulatory intensity, the Eurobond markets and eurocurrency interbank markets were permissive institutions that arose as a result of national legal and regulatory impediments to capital flows of all kinds. Eventually their scale began to rival national markets in banking and securities, leading to protracted negotiations in the early 1990s between industry representatives and regulators that resulted in offshore activity infiltrating national markets and subsuming many disparate local practices. The process became entrenched with the introduction of the euro.

Trade in Financial Services

The framework for foreign participation in national financial services is subject to bilateral, regional, and international negotiations, with the latter concentrated in the WTO process through the GATS. The GATS contains general obligations respecting trade in services, including MFN treatment, transparency, and domestic regulation. As one aspect of its general coverage of services, the GATS addresses financial services. It also includes further elective provisions for financial services liberalization that set generally higher requirements for members. All these commitments form the setting and basis for negotiations addressing liberalization of trade in financial services. The provisions for foreign access are not inclusive, as with trade in goods, their adoption remains in the discretion of WTO members and financial services trade liberalization is thus often limited. In addition, financial services negotiations have made no progress since 1999 in the deadlocked Doha round negotiations.

In respect to interaction with regional frameworks such as the ASEAN AFAS, the GATS does not prevent its members from becoming party to agreements to liberalizing trade in services, and although it contains restrictions on regional economic integration, the WTO process is permissive with regard to regional trade agreements. Since WTO financial commitments overlap with many regional trade agreements, both are relevant to any program for financial liberalization.

The framework is a sound start to supporting foreign competition in financial services trade, but needs to be extended through negotiation and incorporated into international standards. This is important in the relationship between liberalization and financial stability. Acceding WTO members commit to certain levels of financial services liberalization in banking, securities markets, and insurance, but taking such measures without regard for sequencing and safeguards can be a precursor to excessive volatility, and was a consideration in the Asian financial crisis. Analysis of recent crises also indicates the essential function of institutions, including the role of law, enforcement, regulation and legal systems in lessening or making manageable the risks associated with financial liberalization (see Arner 2007). Links in prudential regulation and financial liberalization are increasingly accepted and have been recognized as important in EU regional financial integration.

AFAS Financial Services Sector Commitments

ASEAN’s 1995 Framework Agreement on Services (AFAS) seeks to reduce barriers to trade in services, requiring members to negotiate to lift restrictions in specific market segments and to some degree expand upon their commitments under the WTO’s General Agreement on Trade in Services (GATS). The commitments are not confined to allowing foreign access only to ASEAN members. The following table summarizes ASEAN financial services market access commitments under the ASEAN framework.

ASEAN Financial Services Sector Commitments

APEC

Meetings of APEC finance ministers began in 1993. APEC voiced support for consultations on banking and securities regulation in 1994, and in the same year issued guidelines for regional investment (APEC 1994). In 1996 it endorsed regulatory cooperation and prudential regulation of financial markets in accord with international standards. During the 1997/98 crisis, APEC pronounced itself in favor of stable capital flows, domestic financial market development, efforts to promote financial stability, and work to strengthen regulation of international financial intermediaries and increase cooperation among regulators to lessen global systemic risks.

Asian Monetary Cooperation

Regional monetary cooperation is mainly evidenced by short-term ASEAN+3 central bank credit lines. The 2000 ASEAN+3 Chiang Mai Initiative (CMI) sought to promote cooperation through the institution of bilateral currency swap agreements among central banks (ASEAN 2000). Today’s network of bilateral credit lines has two roots, collaborative foreign exchange swap lines set up by ASEAN’s five original members, and a series of securities repurchase (repo) lines initiated by the Executives’ Meeting of East Asia-Pacific Central Banks (EMEAP) as a precaution after the 1994 Mexican financial crisis (Moreno 1997, 97–100). These origins also reveal two aims, the first political in showing the group’s robustness, and the second intended to assist in economic policy.

ASEAN’s arrangement began in 1977 as a modest $100 million set of foreign exchange swap lines, facilitating simultaneous spot sale and forward purchases of local currency for US dollars among five central banks to assist a member in temporary need of external liquidity. The scheme was extended, expanded, and may have been used once each by Indonesia, Malaysia, the Philippines, and Thailand between 1979 and 1981, and on a second occasion by the Philippines in 1992, in each case for modest amounts (Henning 2002). The arrangement’s limited size and conditionality (requiring a prior IMF arrangement) prevented its use in 1997 when the members’ external positions came most under pressure.

With these swap arrangements came a series of bilateral repurchase lines among EMEAP members, the first introduced in late 1995. Japan was active in their creation, partly due to its interest in promoting regional building blocks distinct from those involving other G-7 members. The lines allowed a participant to raise major currency liquidity for intervention or other purposes by discounting with a fellow member high-grade security held as international reserves, most commonly US government securities. Market practice knows several contexts in which the use of repurchase lines is prolific among both commercial and central banks, but EMEAP’s repurchase lines are analogous to the conduct of money market operations by central banks seeking to influence domestic liquidity, including cases where a central bank accepts collateral in the form of prescribed securities and becomes a lender of last resort. Use of EMEAP lines has no direct consequence for domestic credit expansion. The first repurchase lines were established in 1995–97, prompted by Mexico’s earlier experience and ASEAN’s concerns of contagion. The amounts of these lines were made public only for those involving Japan, each being of $1.0 billion (see Moreno 1997).

Excluding those involving Australia and New Zealand, two sets of lines thus evolved into more complex agreements heralded by CMI. This spurred ASEAN members (now a group of ten) to raise their total swap arrangements to $1.0 billion (later $2.0 billion) and for The PRC, Japan and Korea each to pledge to maintain bilateral credit lines among themselves and with each ASEAN member, allowing currency swaps and securities repurchases. The initiative is not an agreement but an expression of intent, making ASEAN+3 a catalyst to bilateral arrangements already customary among developed economies.

More recently, ASEAN+3 finance ministers have endorsed in principle to augment CMI by creating a new multilateral agreement for the pooling of additional international reserves. This arrangement would involve administrative resources separate from those within participating states and their respective central banks, and is intended to command at least $120 billion in commitments, with the PRC, Japan, and Korea together providing 80% of the total and ASEAN members the remainder. The arrangements would “supplement the existing international financial arrangement” (ASEAN 2008), but in the event that a participating state sought temporary liquidity it is as yet undecided whether conditions for drawings would differ from those of existing multilateral organizations, notably the IMF. The ministers stress that usage would be subject to “rigorous principles”, and there is no sign that ASEAN+3 is inclined to develop distinct conditions for its members. The realization of this proposal would represent the first truly regional arrangement related to monetary cooperation.

Asian Capital Market Development

Post-crisis attention to regional capital market development initially focused on the debt and money markets but has recently begun to consider wider securities market reform, with ASEAN+3 is studying cooperation among exchanges and regulators to assist cross-border trading. Work on debt market development has comprised three collaborative efforts: the ASEAN+3 Asian Bond Market Initiative (ABMI), APEC’s efforts in developing securitization, and work by members of the Asia Cooperation Dialogue (ACD). It also includes EMEAP central banks’ pooling of international reserves in two Asian Bond Funds in 2004 and 2005, with a third fund under discussion.

ASEAN+3, APEC and ACD

APEC’s regional bond market initiative began in 2003, exploring regional market development and institutions to encourage financial activity (APEC 2003). Teams examined aspects of market development, with one seeking recommendations for securitization and credit enhancement mechanisms to improve the credit risk quality of Asian bonds. APEC asked if securitization could provide a continuous fundraising mechanism in the region and assist in the recycling of non-performing financial assets.

Soon afterwards, ASEAN+3 commissioned similar research as part of the ABMI, with working groups given support from ADB resources. They investigated using securitization to increase the supply of debt instruments, enhancing credit risk by providing institutional credit enhancement, improving clearing, custody and settlement systems, developing new credit rating agencies and encouraging information flows, harmonizing market regulations to best practices, and removing legal and regulatory impediments to cross-border bond investment. The final group was charged to explore cross-border local currency bond issuance by multilateral agencies, governments and their agencies, and regional companies. After inaugural issues in the PRC and Thailand by the ADB and the World Bank’s International Finance Corporation (IFC), the group declared its mission ended and it dissolved in 2004.

Pooled Reserves: Asian Bond Funds

EMEAP’s central banks are those from ASEAN’s founding five members, plus Australia, PRC, Hong Kong, China, Japan, Korea and New Zealand. In addition to general central bank cooperation, EMEAP has developed two Asian Bond Funds (ABF1 and ABF2), which pool a fraction of international reserves. The plan had two roots: criticism of Asia massing reserves in non-Asian assets, and the proposition that active capital markets could provide a stabilizing resource in times of heightened volatility. The project had initial assistance from the Bank for International Settlements.

Both funds are indexed and involve no discretionary management. Their aggregate at inception was equivalent to less than 0.15% of the subscribers’ aggregate reserves, but the project is innovative in several respects. While the funds cannot directly contribute to liquidity, they depart from traditional reserve management practice by including sub-investment grade EMEAP sovereign risks. ABF1 is a $1.0 billion pooling of core currency Asian bonds held by EMEAP’s Asian members. The later ABF2 is a $2.0 billion fund for local currency issues, with families of single currency exchange-traded funds and regional index funds each acquiring and holding sovereign and quasi-sovereign Asian securities. Hitherto, proposals to create regional bodies have been ambitious and not easily implemented, for example, currency cooperation pacts discussed at intervals by APEC and ASEAN, so if the more complex ABF2 proved successful it might lead to structural regional cooperation. To date it has prompted the creation of Asia’s first exchange-traded bond fund, led two jurisdictions to permit domestic currency exchange-traded funds, and its regional index fund was the first non-bank intermediary to be granted access to the PRC’s domestic interbank bond market (EMEAP 2005).

Equity Market Development and Cooperation

Asian securities regulators have formed an Asia-Pacific regional committee under the IOSCO umbrella and are engaging in discussions (with support from the ADB) on possible use of IOSCO standards as a basis for cooperation. In this context, as a first step, the ASEAN Capital Markets Forum (ACMF) has now agreed regional standards based upon IOSCO standards for equity and debt securities disclosure.¹

The Role of ADB

The ADB’s Office of Regional Economic Integration (OREI) seeks to promote economic cooperation and integration among the bank’s developing members and contribute to the region’s “harmonious economic growth” (ADB 2005) The ADB provides coordination function for the CMI since 2005, and in established six groups in 2002 to support market development with funding and technical assistance at the same time as the launch of the ABMI by ASEAN+3 (ADB 2004).

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