Financial stability and the reform of regulation & supervision of financial markets – a focus on NMS, by Daniel Daïanu

Summary :

1. Introduction: rationales for examining NMSs’ concerns

2. Reform of the regulation and supervision of financial markets

3.  The financial crisis:  implications for policy construction in NMSs

     3.1 systemic risks and rethinking policies; the Tosowsky dilemma

     3.2 distribution of prerogatives between national and EU authorities;

     3.3 the home-host country relationship

4. Systemic issues and policy action venues:

     4,1 liquidity risk

     4.2 crisis resolution

     4.3 controlling boom and bust creating lending

       - regulatory measures

       - are capital controls an option? 

Appendix

1. Introduction: rationales for examining the NMSs’ concerns:

a. The overall (global) context: not least because of huge/overwhelming externality effects

The negative externalities produced by the financial crisis are huge, in terms of magnitude and the geographic area they cover. Even China and India, which are not mired into economic recession (they only register lower economic growth rates) feel the pinch via, in principal, the compression of international trade and rising protectionism. Negative externalities, which are caused by heavyweights’ policies, are not something new. One could make an analogy with the Fed’s policy turnaround decades ago, when  double digit inflation was brought down by a very severe tightening of US monetary policy. That move threw in disarray countries which had borrowed heavily externally by having been encouraged to do so by negative real interest rates (which followed the recycling of petrodollars). But the current crisis is much deeper, since its roots are structural and embedded in the pattern financial markets have evolved in advanced economies during the past two decades. Waves of deregulation in advanced economies (in the US, UK, in particular) and gross/misleading simplification of the way financial markets operate (including a neglect of systemic risks) have brought about this mess. As Paul Volcker remarked in January 2009 this financial system “has failed the test of the marketplace”. NMSs, like all other emerging economies are deeply interested in a reform of the regulation and supervision which should prevent such deep crises.

b. EU specifics: a single market while national prerogatives remain important.

The EU presents peculiarities which complicate the regulation and supervision of financial markets. While monetary policy is unique in the euro area, the regulation and supervision of financial markets stay in national hands. Massive cross border operations bring to the fore the issue of crisis management, burden sharing and resolution schemes. A convergence in the regulation and supervision does make sense (hence the need for common rulebooks), but this is not enough for an orderly functioning of the single market. In addition, the very functioning if the single financial market has to come to grips with its imperfections –which implies that macroeconomic policies would have to be adjusted accordingly. How an acute concern for financial stability would impact on monetary policy construction and implementation is an example in this regard.

c. NMSs’ circumstances: size, outside the euro-area (except Slovakia and Slovenia), domination of local financial markets by foreign groups; high euroization (except the Czech Republic).

This crisis has hit the NMSs most severely. From the euphoria of accession and pretty high economic growth rates there is now dismay because of deep recession and much worsened prospects for future economic growth. The presence of foreign banks on local financial markets has brought benefits, but it shows its less favorable side too; the credit crunch is adding to the pains of an excessive reliance on capital imports.

d. The rapid expansion of credit (fuelled by foreign lenders) in NMSs

In the currency board using NMSs, in Hungary, Romania credit grew explosively during most of the past decade; rates of over 40-50% yearly were the norm while most of this credit was foreign currency denominated and taken by the private sector. Most worrisome is that a large chunk of this credit was short term. The financial crisis put a stop to further credit expansion. In addition, a “liquidity trap” has amplified the credit crunch and raised the cost of credit to prohibitive heights.

e. Financial integration and convergence

The current financial crisis has underlined pitfalls of seeing financial integration as a main driver of real convergence. Financial markets are more volatile than all others and are more likely to bring about a boom-bust dynamic. The logic of the single market (in the EU) has predisposed NMS to growing external imbalances –due primarily to their inferior economic development and, thence, perceived substantial positive yield differentials of investment opportunities. But many of these investment have been of a speculative nature, or, have been focused on non-tradeables. There has been a rising indebtedness of households and firms in conjunction with weakened potency of monetary policy and budget policy of restricting growing imbalances. A “Dutch disease” syndrome has also been present in NMSs because of an over-appreciation of their currencies (see also Zsolt’s analysis). Some NMS are relatively well integrated into industrial/production networks of the EU and their external imbalances seem to be more manageable. But even for them a too skewed structure of capital ownership can bring about excessive external imbalances. For peripheral emerging economies, which are less integrated in such networks, financial integration has posed more risks and, as the current crisis makes more than clear, the total opening of their capital account has revealed its dark side. The Great Moderation period has created, arguably, a sense of complacency vis-a-vis the growing external imbalances of most NMSs, and it has obscured unavoidable policy-trade-offs. In addition, financial integration has, probably, been overrated as a driver of economic convergence. The current crisis asks for a reassessment of this vision and for policy readjustments (including industrial policies) –be they at national or EU level.  

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The complete article :  Reform of R&S- Jan. 2010