Professional Documents
Culture Documents
Index SR - No. Topic No
Index SR - No. Topic No
Topic
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. Executive Summary Introduction Theory of International Banking International Trade in banking Services International Payments System Interbank Markets Costs and Benefits of International Banking Multinational Banks Multinational Banking Indias Future Of Its Vision in the World Global Integration in Banking Recent Developments in banking Case Studies Articles Conclusion Bibliography
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EXECUTIVE SUMMARY
INTRODUCTION
The emphasis is on the theory and practice of international banking, because of its critical importance in the modern banking framework. International banking is not a new phenomenon; international bank activity can be traced back to as early as the 13th century. In this topic we understand the difference between Indian banking and international. International banking helps us to know how important international banking for the progress of India and also for the counter. It is one of the most important factors responsible for economic growth of the nation.
currencies other than the home currency that is, the currency of the country in which it is chartered. Other authors have advocated the use of the other definitions. The problem with all of the above definitions is that they are trying to give one answer to two separate questions in international banking. In formulating a definition, it is important to distinguish between the international activities of a home based bank, and the establishment of cross border branches and subsidiaries. The existence of international bank service activity is explained by the traditional theory of international trade, while multinational banking is consistent with the economic theory of the multinational enterprise. Thus, to gain a full understanding of the determinants of international banking, it is important to address two questions : Why do banks engage in international banking activities such as the trade in foreign currencies? What are the economic determinants of the multinational bank, that is, a bank with cross border branches or subsidiaries?
International trade theory may be used to address the issue of why banks engage in the trade of international bank services. Comparative advantage is the basic principle behind the international trade of goods and services. A country is said to have comparative advantage in the production of a good (or service) if it is produced more efficiently in this country than anywhere else in the world. The economic welfare of a country increases if the country exports the goods in which it has a comparative advantage and imports goods and services from countries which are relatively more efficient in their production. At firm level, firms engage in international trade because of competitive advantage. The exploit arbitrage opportunities. A firm will export a good or service from one country and sell it in another because there is an opportunity to profit from arbitrage. The phenomenon of trade in international banking services is best explained by appealing to the theories of comparative and competitive advantage. In banking, the traditional core product is an intermediary service, accepting deposits from some customers and lending funds to others. The intermediary function involves portfolio diversification and asset evaluation. A bank which diversifies its assets can offer a risk / return combination of financial assets to individual investors / depositors at a lower transactions cost than would be possible if the individual investor were to attempt the same diversification. Banks also offer the evaluation of credit and other risks for the uninitiated depositor or investor. The bank acts as a filter to evaluate signals in a financial environment where the amount of information available is limited. If banks offer international portfolio diversification and/ or credit evaluation services on a global basis, they are engaging in the international trade of their intermediary service. For example, a bank may possess a competitive advantage in the evaluation of the riskiness of international assets, and therefore, its optimal portfolio of assets will include foreign currency denominated assets.
A by- product of intermediation is bank participation in the payments system, including settlement, direct debit, and chequing facilities. If some of its corporate or retail customers engage in international trade activity, they will require global money transmission services. The simplest example is the provision of foreign exchange facilities across national frontiers is now well developed. In parts of Europe, it is possible to use a debit card from one state (for example, the UK) to obtain local currency in another state (for example, Spain). To conclude, if a bank offers its intermediary or payments services across national boundaries, it is engaging in international trade activities and is like any other global firm which seeks to boost its profitability through international trade.
which amounts to about 11000 users. In 1992, there were 68 million FEDWIRE funds transfers, with a value of $199 trillion. The average size of a transaction is $3 million. CHIPS, the Clearing House Interbank Payments System, is a New York based private payments system, operated by the New York Clearing House Association since 1971. CHIPS is an online electronic payments system for the transmission and processing of international dollars. Unlike FEDWIRE, there is multilateral netting of payments transactions, and net obligations are settled at the end of each day. At 1630 hours (eastern time), CHIPS informs each participant of their net position. Those in net deficit must settle by 1745 hours, so all net obligations are cleared by 1800. Most of the payments transferred over CHIPS are international interbank transactions, including dollar payments from foreign exchange transactions, and Eurodollar placements and returns. It also makes payments associated with commercial transactions, bank loans, and securities. Obligations on other payments or clearing systems can be settled through CHIPS. In 1992, there were 40 million payments, valued at $240 trillion. CHAPS : London based, the Clearing House Automated Payments System was established in 1984 and permits same day sterling transfers. There are 14 CHAPS settlement banks, including the Bank of England, along with 400 other financial firms which, as sub-members, can engage in direct CHAP settlements. The 14 banks are responsible for the activities of sub-members, and settle on their behalf at the end of each day. The closing time in 1510 hours (GMT). The Bank of England conducts a daily check of the transfer figures submitted to them. In 1992, the total value of payments through CHAPS was $20 928 billion, equivalent to a turnover of British GDP every seven days. There are other payments systems in the UK; CHAPS is for high-value, same-day sterling transfers. CHAPS accounts for just over half the transfers in the UK payments system; the average daily values transferred through the UK system was $161 billion in 1993. A framework for introducing real time gross settlement was drawn up in 1993. It will mean transactions across settlement accounts at the Bank of England will be settled in real time, rather than at the end of each day.
A number of the large global banks run their own electronic payments systems, primarily to facilitate internal global payments. These systems are run alongside SWIFT and other public systems. The internal systems are also used to attract corporate business. For example, Chase Manhattan and Citibank have offered a relatively cheap transfer service for their corporate clients. SWIFT is the most popular electronic fund transfer system because if offers real time gross settlement 24 hours a day and is a cooperative, non-profit maximizing system. CHIPS and CHAPs were criticized for their limited opening hours and excessive charges, especially for erroneous messages. Also, member banks (money centre banks in the US, clearing banks in the UK) effect transactions in CHIPS and CHAPS, so competitors must use these banks as their agents. All three systems have problems arising from complex and incompatible software, leading to high staff training costs. A potential competitor in the future will be a secure internet system which use e-cash to settle transactions in real time.
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pricing in domestic markets, for those customers who have the option of going offshore (mainly corporates).
International banking activities can also be responsible for a number of welfare costs. First, revenue for central government may be reduced. If a central bank imposes reserve requirements on deposits in the banking system, the introduction of international banking facilities will lead to the flow of funds out of the domestic banking system and into the international system where deposit rates are higher. A reserve ratio requirement is a form of taxation on the banking system because it requires idle funds to be held at the central bank. The reduced volume of domestic deposits as they move offshore will reduce government revenues accruing from this source. These will be reduced still further if the competition forces the central bank to abandon the reserve ratio requirement, or eliminate controls on deposit rates. To make good the loss from the implicit tax on bank reserves, the government may impose a new type of distortionary taxation. Second, the international banking system is not truly global, because it is largely confined to the wholesale banking market. This means there is discrimination in loan and deposit rates, those having access to the offshore banks getting more favourable terms than their fellow nationals. Since only some of the customers in a national economy gain, it will not be possible to judge whether there is a net gain accruing to residents of a give country. Third, the diversion of banking activity from onshore to offshore alters the real resource costs of banking. Whether they increase or decline is governed by the cost differential between inshore and offshore banking. The movements of the loan and deposit rates in the Euromarkets since their operation began suggests the real resource costs have been lower. But they may have been underestimated for several reasons. For example, the banks underestimated the cost of lending in the Eurocurrency markets, especially in the case of sovereign loans; banks thought this type of lending was almost risk free, because a country could not be declared insolvent. More
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generally, banks lack experience in setting the prices for newer financial products, commensurate with their risk. Information asymmetries are normally more pronounced in international banking. In a domestic system a bank officer is able to assess creditworthiness on the basis of direct knowledge about the borrower. In the Euromarket only the final lender has certain knowledge of who the borrower is, the average deposit passing through several banks before being loaned to a non-bank borrower. Often, the exposure of other banks in the Euromarkets is unknown to each individual bank. If global banking aggravates information difficulties, confidence is undermined, making bank runs more likely. In 1984, the Institute for International Finance (IIF) was established by banks to collate information on international bank activity. Its establishment suggests banks thought they may have underestimated the costs of information gathering in international banking. But it may not be the optimal solution. Given increasing return to the pooling of costly information, the IIF may not be the most cost effective way of collecting information, because it consists of a small coalition of international banks. Also, it could encourage oligopolistic tendencies in international banking. To conclude, there have been both welfare costs and benefits associated with the development of international banking. Though some of the resource costs associated with international banking are difficult to quantify, it is generally accepted that the net welfare effects have been positive because new flows of capital created by the system have increased global productivity.
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market imperfections. For example, US regulations in the 1960s effectively stopped foreigners from issuing bonds in the USA and American companies from using dollars to finance foreign direct investment. US banks got round these restrictions by using their overseas branches, especially in London, because it was a key centre for global finance. Later, these banks used their London subsidiaries to offer clients investment banking services, prohibited under US law. Additionally, the nature of banking means banks possess a number of intangible assts which cannot be traded in the market place. For example, a bank may wish to profit from the employment of superior management skills in a foreign country, provided locational efficiency conditions are met. Thus, US banks with management expertise in securitization may transfer these experts to their London subsidiaries, as the securitization may transfer these experts to their London subsidiaries, as the securitization business in Europe grows. Japanese banks have established subsidiaries in London and New York, where the markets are subject to fewer regulations than in Japan. This move was partly motivated by a belief that experience gained in other markets would give bankers a competitive edge in the event that Japanese financial markets are deregulated. Reputation is an important intangible asset possessed by banks. Many of the London merchant banks have established offices in other countries, to exploit their reputation for expertise in corporate finance, and other investment banking services. It is not possible to sell reputation on an open market. Provided locational efficiency conditions are met, reputation may be a profitable reason for a bank expanding across national borders. Many authors (for example, Coulbeck, 1984) have argued that MNBs exist because banks need to follow their corporate customers overseas. The theory outlined above is not inconsistent with this traditional explanation. Suppose the customer of a bank decides to set up a subsidiary in a foreign country. The lending bank may follow the customer to meet the service demands of the client. In the days of colonial trade, when banking systems were underdeveloped, this factor was more important than today, when firms are expanding into countries, which, in most cases, already have well developed banking systems. But even if the multinational has operations in a developed economy with an extensive banking system, it may wish to employ
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the services of a home country bank because the cost of local bank credit, with no local knowledge of the firm, is likely to be higher. Additionally, the bank may follow the corporate customer overseas to protect its own assets. If the bank is going to lend funds to a multinational firm, it will require information on the foreign operations to properly assess the creditworthiness of the client. The optimal way of gathering information may be the establishment of a branch or subsidiary in the foreign country. Effectively, the bank internalizes the implicit market for this information. To summarise, the term international banking should be defined to include two different activities : trade in international banking services, consistent with the traditional theory of competitive advantage for why firms trade, and MNBs, consistent with the economic determinants of the multinational enterprise. Having classified international banking in this way, attention will now turn to developments in international banking services and multinational banking.
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MULTINATIONAL BANKING
Historical Background Multinational banks (MNBs) are banks with subsidiaries, branches, or representative offices which spread across national boundaries. They are in no way unique to the post war period. For example, from the 13the to 16th centuries, the merchant banks of the Medici and the Fugger families had branches located throughout Europe, to finance foreign trade. In the 19th centuries, MNBs were associated with the colonial powers, including Britain and, later on, Belgium, Germany and Japan. The well known colonial MNBs include the Hong Kong and Shanghai Banking Corporation (HSBC), founded in 1865 by business interests in Hong Kong specializing in the China trade of tea, opium and silk. Silver was the medium of exchange. By the 1870s, branches of the bank had been established throughout the Pacific basin. In 1992, the colonial tables were turned when HSBC acquired one of Britains major clearing banks, the Midland Bank. The National Bank of India was founded in 1863, to finance Indias export and import trade. Branches could be found in a number of countries trading with India. The Standard Bank was established in 1853 specializing in the South African wool trade. Headquartered in London, it soon expanded its activities to new developments in South Africa and Africa in general. Presently it is known as the Standard Chartered Bank, and though it has a London head office, the bank does virtually no domestic business in the UK. By 1914, the Deutsche Bank had outlets around the world, and German banks had 53 branches in Latin America. The Societe Generale de Belgique had branches in the Belgian African colonies, and the Mitsui Bank established branches in Japanese colonies such as Korea. All of these banks were colonial commercial banks because their primary function was to finance trade between the colonies and the
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mother country. Branches were normally subject to tight control by head office. Their establishment is consistent with the economic determinants of the MNE, discussed earlier. Branches meant banks could be better informed about their borrowers engaged in colonial trade. Since most colonies lacked a banking system, the home country banks foreign branches met the demand for banking services among their colonial customers. A number of multinational merchant (or investment) banks were established in the 19th century good examples are Barings (1762) and Rothschilds (1804). They specialized in raising funds for specific project finance. Rather than making loans, project finance was arranged and stock was sold to individual investors. The head office or branch in London used the sterling interbank and capital markets to fund the project finance these banks were engaged in. Capital importing countries included Turkey, Egypt, Italy, Spain, Sweden, Russia, and the Latin American countries. Development offices associated with the bank were located in the foreign country. Multinational merchant banks are also consistent with the economic determinants of the MNE. Their expertise lay in the finance of investment projects in capital poor countries; this expertise was acquired through knowledge of the potential of the capital importing country (hence the location of the development offices) and by being close to the source of supply, the London financial markets. There was rapid expansion of American banks overseas after the First World War. In 1916 banks headquartered in the USA had 26 foreign branches and offices, rising to 121 by 1920, 81 of which belonged to five US banking corporations. These banks were established for the same purpose as the 19th century commercial banks, to finance the US international trade and foreign direct investment of US corporations, especially in Latin America. In the 1920s, these banks expanded to Europe, in particular Germany and Austria. By 1931, 40% of all US short term claims on foreigners were German. A few American and British banks established branches early in the 20th century, but the rapid growth of MNBs took place from the mid 1960s onward. Davis (1983) argued that in this period banks moved
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from a passive international role, where they operated foreign departments, to one where they became truly international by assuming overseas risks. However, such an argument makes ambiguous the distinction between the MNB aspect of international banks and trade in international banking services. As expected, the key OECD countries, including the USA, UK, Japan, France, and Germany, have a major presence in international banking.
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A partnership-based programme The Foreign Policy Centre is working with a number of leading Indian think tanks and other partners in various fields, including: Indian investors in Europe UK investors in India Prominent journalists, academics and opinion formers Indian diaspora organisations in Europe, especially the UK NGOs, think tanks and research organisations Aims and context Indias influence on global affairs is evident in a number of spheres from academia and development theory to business, technology and movies. As suggested by the Goldman Sachs report, Dreaming With BRICs: The Path to 2050, the economies of Brazil, Russia, India and China (BRIC) together could be larger than the G8 in dollar terms in fewer than 40 years. Despite Indias small share of world trade at present, its economy could be larger than all but the US and China in 30 years. The rise of the BRICs will be critical for how the world economy evolves. Two issues will inevitably shape Indias rise. First, Indias projected economic power will mean that it will be a strong force in determining international market practices and influencing decisions in the multilateral trading system. Second, as the largest democracy in the world, India enjoys unique political legitimacy which means that it is held up as a role model and a progressive influence in global affairs. In the words of Sunil Khilnani, India needs to make use of the democratic dividendand be willing to play a role in the global battle of ideas. Most analysts agree that India has yet to find a voice in world affairs appropriate to its power and potential and that Indias role on the
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world stage remain unclear. In the short term, key questions remain about how it relates to the West and other emerging powers, especially China. More long term, India has yet to stake out its position as a progressive international player, a positive broker in the pursuit of multilateral solutions to global problems and an active player in the promotion of liberal democracy around the world. Through an interchange between small groups from India, Europe, the US and selected other countries, the Foreign Policy Centres programme will explore how India will engage with the world over the first decades of the 21st century. It will aim to address clear questions about Indias future. How is globalisation shaping Indias worldview and sense of itself? How will India look to shape its own global role? How will Indias new role impact on the international system? The programme will examine a variety of cutting edge issues and new ideas focusing on five areas: International political values, multilateralism and international security Evolving international economic configuration, trade and finance Democracy, pluralism and harnessing variety
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Many observers believe that significant global integration is under way in the banking industry and that, in the coming years, individual banks will expand their reach into many countries. Likewise, these observers expect that many national banking markets will develop large foreign components; as that happens,the nationality of a bank in such market will matter little to prospective customers. 1. These forecasts are based on the observation that, over the past two or three decades, many nations have removed important regulatory barriers to international banking. Advances in technology also now allow financial institutions to manage larger information flows across more locations and to evaluate and manage risks at lower costs than ever before. Together, these developments have reduced the costs of supplying banking services across borders. At the same time, growth in the international activities and trade of multinational corporations has increased the demand for services from financial institutions that operate across borders. Despite these developments, the banking industry appears today to be far from globally integrated, particularly in industrialized countries.
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For example,the foreign share of bank assets in most industrialized countries remains at or below 10 percent. And although bank consolidation has been intense within industrialized countries, mergers and acquisitions across the borders of these countries have been much less common 2. To evaluate more closely the extent to which bankingis becoming globally integrated, we study the nationality and international reach of banks that provide financial services across Europe to affiliates of multinational corporations. We examine these affiliates because they are among the customers most likely to demand the services of international banks,
and we focus on Europe because barriers to financial integration have been extensively reduced on thatcontinent. A finding that banking integration has advanced little even under such favorable conditions would cast doubt on the prospects for the globalization of banking more generally. The 1996 survey of the short-term banking practices of more than 2,000 European affiliates of multinational corporations. Perhaps surprisingly, we find that close to two-thirds of these affiliates choose a bank headquartered in the nation in which they are operating (a host-nation bank) rather than a bank from their home country or a third nation. Moreover, having chosen a host-nation bank, an affiliate is more likely to select a bank limited to local or regional operations rather than a large bank with global reach. The time-series data that might reveal the degree to which global integration has increased over the past decade. These data cover European syndicated loans, the ratio of domestic private bank claims to total (domestic plus foreign) bank claims, and the dispersion of nonfinancial goods prices across Europe. In brief, the time-series data show a picture for the current period that is not substantially different from that at the time of the 1996 survey. These results are consistent with the idea that affiliates Value host-nation banks over others because host-nation banks better understand their own market and may possess superior
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information about local nonfinancial suppliers and customers. The results also imply that affiliates that have chosen host-nation banks value the more customized and relationshipbased services offered by banks with local or regional reach, as opposed to the broad-based services offered by a host-nation bank that has global reach. Even as economic forces push toward globalization, the high demand for hostbased expertise by bank customers, coupled with the competitive advantages that host-nation banks have in providing this expertise, implies that many banking services could very well remain local. In other words, banking markets need not become much more integrated as the globalization of other economicsectors continues.
RECENT DEVELOPMENTS
Banking crises in emerging markets in the 1990s were associated with major macroeconomic disruptions: sharp increases in interest rates, large currency depreciations, output collapses and lasting declines in the supply of credit. Bank credit has since recovered in a number of countries, and there have been significant changes in banking structure, performance and risk management capacity. Drawing on contributions by senior central bank officials from emerging market economies and staff of the Bank for International Settlements, the volume seeks to shed light on recent developments by addressing five broad topics. 1. Recent trends in bank credit After peaking in the second half of the 1990s, bank credit to the private sector has recently risen in a number of emerging market economies, partly because of stronger demand for loans associated with robust growth and low interest rates, and partly because of greater supply of loans associated with improved bank balance sheets. The share of bank credit to the business
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sector has nonetheless declined in part because lagging investment spending has curbed corporate loan demand, and also because of the availability of financing in bond and equity markets. In some countries risk averse banks have held government securities rather than lend to the corporate private sector. Financial institutions have increased lending to households but this exposes them to new forms of risk, as illustrated by difficulties in the credit sector in Korea earlier in this decade. One concern is that banks in some countries have transferred a significant amount of interest rate or exchange rate risk to households through floating rate credit or loans denominated in foreign currency.
2. The pace of structural change Banking systems in emerging economies have been transformed by privatisation, consolidation and foreign bank entry. Bank efficiency and performance have improved, apparently in response to a more competitive climate. More recently, reforms appear to have slowed, in part because the easy work had been done and because of alternative approaches to reform. For example, rather than engaging in full scale privatisation, countries like China and India are only gradually transferring ownership of major state-owned banks to the private sector. As for bank consolidation, it has been market-driven and foreign banks have played an important role in central and eastern Europe and Mexico, while the state has played a larger role in Asia. Increased concentration was not seen as a threat to competition and access to bank financing had improved with the growing presence of foreign banks. However foreign banks raised political concerns because of perceived high profits and were also difficult to supervise because parent banks' global goals and information flows did not always coincide with the needs of host country supervisors. 3. Evolution in and management of risks facing banks
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Macroeconomic vulnerabilities (particularly to external shocks) appear to have declined, reflecting a mix of favourable temporary conditions as well as improved policies (higher foreign reserves, more flexible exchange rates, domestic debt market development and improved fiscal policies). However, some central banks were still concerned about vulnerability to certain shocks (eg to domestic demand, to increases in oil prices or interest rates or declines in property prices), particularly given the exposure of banks to interest rate or exchange rate risk and the need in some countries for further fiscal consolidation. Banks increasingly relied on systematic risk assessment procedures and quantitative risk management techniques, with lending being influenced less by government direction or special bank relationships with borrowers. However, challenges still arose from lack of data on loan histories for estimating default probabilities, and risks related to liquidity and credit risk transfer. Regarding liquidity risk, there is a need to ensure that banks rely on the interbank markets, rather than the central bank for liquidity. Regarding credit risk transfer, notwithstanding significant benefits associated with the growing use of credit risk transfer instruments, their rapid spread might in some cases outpace the capacity of financial institutions to assess and price risks.
4. Preventing systemic banking crises One indicator of stronger banking systems is that the volatility of output and inflation has fallen in emerging market economies while their capital ratios have risen significantly. This reflects (i) policies designed to improve bank governance and information disclosure that enhances market discipline, (ii) regulatory measures to dilute risk concentration, limit connected lending, establish realistic provisioning rules and to improve inspection process; (iii) the evolution in supervisory strategy from "ratio watching" (checking bank positions against predetermined prudential ratios) to examining the bank's risk management process. The ability to take early action to deal with incipient problems before a crisis develops has also been enhanced by
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increased authority, independence and legal protection for supervisors. At the same time, explicit and limited deposit insurance has helped make clear that not all bank deposits are guaranteed by the government. The payment of fixed premia have encouraged banks to monitor the strictness/effectiveness of supervisory authority and ensured weak banks share the burden of any payouts. Some of these improvements have been helped by efforts to adopt international standards for best practice (Basel Core Principles for Effective Banking Supervision, Basel I and Basel II) and outside assessments of financial stability (ie Financial Sector Assessment Programs, or FSAPs). Challenges remain, including changing the culture in supervisory agencies as well as audit departments of banks towards more effective risk management, and the lack of adequately trained staff.
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Indian banking global benchmarks. Today it is Global banking paradigm shift. This subtle change of emphasis in themes from Indian banking to global banking clearly reflects todays reality: the increasing globalisation of the Indian economy. Over the past decade, India has emerged as one of the fastest-growing economies on the globe. The rest of the world has been impressed to see that the reforms initiated in the early 1990s are bearing fruit. To sustain any countrys growth, of course, a strong and dynamic financial sector is essential. What can governments and central banks do to nurture a more efficient and competitive financial industry and at the same time maintain the stability of the system as a whole? This question is central to the international deliberations on financial policy that take place at the Bank for International Settlements.
The BIS and its various committees of experts play a major role in shaping the policies, standards and so on that help to ensure global financial stability. There are a few of the important committees and groups. One is the Committee on the Global Financial System (CGFS). This Committee regularly monitors the latest developments in financial markets worldwide, and also investigates how structural changes affect the working of the global financial system. Representatives of the Reserve Bank of India are active participants in the work of the CGFS. Another key committee is the Basel Committee on Banking Supervision, with which many of you will be familiar. The Basel Committee formulates broad supervisory
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standards and recommends guidelines for sound practices in the areas of banking system supervision and regulation. The Basel Committee does not enforce compliance with the standards it issues. Rather, the expectation is that national authorities will take steps to put in place the
necessary arrangements, statutory or otherwise, that are best suited to their own national systems. The BIS Financial Stability Institute (FSI) helps financial sector supervisors to implement these standards and so strengthen their financial systems. A large number of conferences, high-level meetings and seminars are held by the FSI in Basel as well as in different regions around the world. The FSI also offers an online learning tool FSI Connect that is helping to train banking supervisors in some 95 jurisdictions around the world. The FSI and the BIS generally have deepened their contacts with the financial industry in recent years. The Basel II process provides one recent obvious instance. This revision of banks capital adequacy requirements was undertaken over a period in which consultation with the private sector throughout the world, not just in the main financial centres was intense and continuous. This dialogue between the private sector and the official sector is becoming more and more important. And this is why conferences such as this one can be so stimulating and productive. The three themes related to the interface between the financial markets and various elements of the regulatory framework that I believe are relevant to global banking today. The first theme is: market forces and the rationale of Basel II . Because global market forces are increasingly shaping the structures of national banking systems, supervision needs to be conducted in ways that harness market discipline. The second is: the importance of market contestability . Technological developments and international agreements on financial services are making financial markets ever more contestable.
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The third is that effective market discipline depends on the harmonisation of standards . Global integration is creating a need for some degree of harmonisation in this area.
(i) Market forces and the rationale of Basel II Technology, deregulation and liberalisation have reinforced market competition, locally and internationally. Banks now have significant operations beyond their domestic borders and are handling a large amount of business and millions of non-resident clients across the globe. In the process, large, internationally active financial institutions with complex risk profiles have grown in size. Other domestic banks and institutions are also forging stronger cross-border linkages by acquiring customers abroad. Three related changes have also been important. One: In the past, it was frequently the regulators who directly limited banks business and risk-taking and very often shielded banks from competition. Now banks across various jurisdictions are able to take most of their own decisions and face the consequences. They also have to withstand more competition. These developments have inevitably focused the minds of senior bank managements on the significance of managing risks. Two: The economic context in which banks operate has changed. There is an increasing emphasis on shareholder value, which leads banks to focus on improving risk-adjusted profitability, rather than simply boosting business volumes. Banks are more aware of risks in their business and of the need to use their scarce capital resources effectively. They constantly develop and seek to improve sophisticated tools for assessing, monitoring and managing risks. Three:
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Banks now face increased competition from the alternative sources of finance that open capital markets provide. At the same time, various capital market instruments are now available to banks that can help them to manage their risk profiles in a more flexible manner. Banks not only need to price their products based on a better assessment of risks, but they also need to
really understand the advanced products that are available to mitigate or manage risks. All these market developments are forcing banks to take a closer look at their risk management systems and procedures as they seek to better manage their business in a changing global banking scenario. What the international standard setters and regulators are trying to do is to devise mechanisms of regulation and oversight that are well adapted to this new environment. As the market and business environment evolves, so also must the international regulatory framework. Basel II is an important step forward in this direction. The basis for Basel II was already provided by the 1988 Capital Accord, often referred to as Basel I. Basel I has become widely used indeed more than 100 countries around the world have implemented this standard. In the light of the market developments that I have just mentioned, however, Basel I has become outdated, especially for the large, sophisticated banks. It is also not sufficiently risk-sensitive for the more competitive and more complex banking business that has emerged over the past decade. The three pillars of Basel II represent a much more comprehensive approach to the greater complexity of present-day banking. As you know, Pillar I covers capital adequacy requirements. Under Pillar II, supervisors will review not only a banks calculation of its need for capital, but also how the bank manages a wide array of risks. Third, but by no means least, Pillar III will ensure that banks achieve the high standards of public disclosure that are needed for market discipline to be effective.
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The importance of market discipline brings the second theme: (ii) The importance of market contestability Technology and international agreements on financial services have already made global banking a reality in many countries, and are increasingly doing so in many others. This means that countries need to ensure that their banking and financial markets can adapt to a more competitive environment. The contestability, or competitionfriendliness, of a market is the key issue here. The degree of contestability varies directly with how easy it is for new firms to enter the market. The regulations that govern actual operations also shape contestability. Increased competition enables the provision of a broader range of services, reduces price distortions and cuts costs for firms and households. It also helps to transfer new technology and skills into the market, as well as new products and management techniques, which improve the overall efficiency of the market. Contestability has various dimensions. Domestic institutions must feel some impetus to achieve greater efficiency and new banks should be allowed to access the market and compete without significant regulatory constraints. The partial privatisation of public sector banks in India involving a substantial injection of private shareholding has been a notable step forward. So too has the establishment of 12 new private sector banks since 1993. Foreign direct investment (FDI) in the financial sector is also very important. A recent comprehensive report by the CGFS found that local banks exposure to global competition boosted the efficiency of the local financial sector in a lasting way. Competition from foreign firms forces local banks to reassess their lending practices. The result has often been better risk management1 and more diversified lending portfolios and hence safer banks. The steps taken by India in recent
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years to allow greater FDI in domestic private sector banks and to permit the establishment of foreign banking subsidiaries in India are therefore to be welcomed. It needs to be recognised, however, that managing foreign bank involvement in the domestic financial system is a challenge. BIS workshops held in Asia, Latin America and eastern Europe brought to light several important #
dilemmas that policymakers face.2 A common theme of these workshops was that good communication between home and host country authorities in charge of financial sector oversight was essential. But the issues raised were much broader than just information exchange between supervisors. Aspects such as the availability of market information and the effectiveness of market discipline, corporate governance, coordination in crisis situations and emergency liquidity assistance were all considered to be of great importance. Again, dialogue between the public and private sectors on these issues would be particularly fruitful. (iii) Harmonisation of standards The three themes: that effective market discipline depends on the harmonisation of standards. As barriers to the establishment of foreign banks and to the cross-border provision of financial services come down, increased attention is being given to the harmonisation of accounting standards and arrangements across countries. Harmonisation does not mean homogeneity. Rather, it implies a necessary degree of commonality in standards to ensure competitive equality. This is not a goal that is easily attained. The fundamental challenge is to find sufficient common ground for an international framework that promotes broadly consistent results or a level playing field in the face of the very real differences that exist across countries in terms of legal systems, market practices and business conditions. Finding such common ground invariably involves compromise, which means that the result is unlikely to be that which a country acting on its own would have adopted.
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The process of harmonisation of accounting standards began several years ago and is being coordinated by the International Accounting Standards Board (IASB). A number of international financial reporting standards (IFRS) have been finalised and have been applicable to all listed companies in the European Union since 1 January 2005. Several other countries have also adopted IFRS as their national accounting standards. It is estimated that more than 90 countries will either permit or require the use of IFRS before or during 2007 for publicly traded companies.
In addition, a number of other countries are putting in place a formal policy to bring their national standards into line with IFRS. The Securities and Exchange Commission of the United States has also expressed strong support for convergence between IFRS and the United States Generally Accepted Accounting Principles (US GAAP). The Financial Accounting Standards Board (FASB) of the US and the IASB are now working towards finding common ground between IFRS and US GAAP. Many of the Indian commercial banks currently prepare their statements under US GAAP, in addition to adhering to Indian accounting standards. Convergence between Indian and international accounting standards has been adopted as a formal policy of the Institute of Chartered Accountants of India. Moreover, India has been involved in the Standards Advisory Council of the IASB, which meets periodically to inform and advise the IASB on various issues relating to accounting standards. All this is welcome. Adopting common financial reporting should be a major step towards improving the efficiency of international financial markets. It will reduce barriers to both trade and the flow of capital. Investors will have access to more reliable financial data to assess corporate performance in many jurisdictions. As issuers of securities, companies will be able to attract investors more easily, potentially reduce their cost of capital, and save the costs of having to conform to many different requirements in different jurisdictions. Audit firms will be better able to assure the quality of audits among national partner firms. Financial sector supervisors and regulators will benefit from the
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greater consistency and quality of information. Ultimately, the adoption of such common standards will lead to increased opportunities for global investment, and will boost employment and growth globally. Not surprisingly, then, there is growing momentum in the adoption of IFRS across jurisdictions. Summarising three main issues. First, global banking is becoming a reality in more and more countries. Financial firms are operating in an increasingly open, global and competitive environment. Banks have to adapt to an environment that makes effective risk management all the more important.
Supervisory oversight also needs to continuously evolve to keep pace with market changes. Basel II is an important step in this direction. Second, greater domestic and foreign competition can lift the efficiency of local banks and other financial institutions. This is a development to manage, but not to impede. Finally, accounting standards need, as far as possible, to become more harmonised internationally. The work of the IASB is therefore of major importance in helping market discipline to work effectively.
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