The emerging market perspective

First, the G20 co-opted them into the global high table of financial regulation through the restructured Financial Stability Forum (FSF), hitherto a preserve of AEs.

Second, most of these reforms would not be implemented immediately in EME financial systems that are still fundamentally different from those in AEs.

Third, EMEs stand to gain from a ?safer? financial system in AEs because as net savers much of their own financial intermediation is routed through it. A shock in AE financial systems automatically transmits to EMEs through sudden stops and attendant currency crises that can derail their economies as happened recently.

Financial panics are often preceded by escalating leverage with maturity mismatches. Drivers of leverage in AEs and EMEs are, however, different. In AEs, the primary driver for leverage was consumption and to increase the return on capital through increased trading of claims and re-claims on real assets in an environment of low returns. This led to rapid expansion of financial assets as a proportion to GDP through the shadow banking system. High credit growth in EMEs, like China and India, was linked to high rates of investment and growth through commercial banking. EMEs are far less leveraged and financialised and their banking systems remain mostly deposit based.

Deposit insurance and central bank discount windows make EME financial systems less susceptible to financial panics and bank runs. Their central banks also deploy macro-prudential tools to ensure that financial bubbles are contained. Unsurprisingly, therefore, while EMEs were affected by sudden stops from abroad, their financial intermediation held up, even as it froze in AEs with their growing reliance on shadow banking.

The impact of the ongoing financial regulatory reforms on EMEs has been relatively benign so far. Despite the general decline in cross-border claims on financial assets amongst AEs, capital flows to EMEs are back to pre-crisis highs. This is perhaps aided by the long phase-in period for Basel III, and the preponderance of FDI in these flows. TNCs, which drive these flows, never lost access to capital markets during the global financial crisis (GFC). Capital flows to EMEs have been more impacted by monetary policies in AEs than their regulatory reforms.

Unlike in AEs, EME concerns are more developmental than regulatory: increasing savings to accelerate growth; deepening the financial system to develop long-term funding instruments for infrastructure financing; absorbing large inflows of capital to counter the backwash from EMEs to AEs; and reducing the cost of capital and leads and lags in monetary policy transmission. AEs, on the other hand, need to roll back extreme forms of financialisation that expose them to greater financial risks without commensurate gains in economic growth.

Basel III is one area where the new regulatory norms will impact AMEs and EMEs almost equally at the same time. Indeed, EMEs are actually ahead of AEs in implementation. However, while banking capital needs to be strengthened in both AEs and EMEs, the rationale for tightening capital norms in EMEs is not self-evident. Capital norms in AEs need strengthening as financialisation of their economies has heightened systemic risks. In EMEs, on the other hand, additional banking capital was needed even under Basel II norms to address issues of rapid credit and economic growth. There is now a probability that migration to Basel III may divert scarce savings in EMEs away from critical investment needs to cover risks benchmarked to AE financial systems, keeping the cost of capital high in the foreseeable future.

Shadow banking: Both AEs and EMEs have flourishing shadow banking systems. In China, it accounts for a little over 40% of total financial intermediation, as against about 25% in the US, UK and the euro area. Despite superficial similarities, however, the driving force, structure and relationship with commercial banks are different in AEs and EMEs. This reflects the fundamental underlying difference that while shadow banking in AEs is a measure of their financial depth, in EMEs it is a measure of their financial repression, as they try to channelise household savings into providing low-cost funds for investment and government developmental programmes.

The similarities are no doubt striking. First, there are strong linkages between commercial and shadow banking. Second, authorities have avoided regulating shadow banks to promote financial inclusion, including home ownership. Third, the growth of shadow banking stems from a demand for higher returns, in AE because of easy monetary policy and a global savings glut, and in EMEs because of low real returns on account of financial repression.

The differences, however, are stark. First, the exposure of commercial banks to shadow banking was mostly off-balance sheet in AEs, whereas in EMEs it was direct because it was permitted, even encouraged, by regulators to promote financial inclusion. While sub-prime borrowers in the US may not have been credit worthy for housing finance, they were never excluded from the banking system as in EMEs.

Second, while shadow banking in EMEs channelised savings to risky borrowers at high rates of interest, in AEs shadow banking created money through a sharp increase in its velocity through repeatedly leveraging??rehypothecating??the same pool of underlying assets. In other words, while shadow banking in EMEs was through vanilla credit instruments that converted savings into investment, in AEs it created money through innovative money market instruments.

Third, shadow banking loans and mortgages in EMEs are refinanced by commercial banks, much like Fannie Mae and Freddie Mac in the US. However, they are not securitised and taken off the balance sheets of both the loan originator and refinancing bodies through market sales. In India, the loan originator retains the loan on its balance sheet, thereby ensuring credit quality. Since these loans are backed by real assets, the threat of dispossession keeps loan delinquency low. Delinquency is also low also because the borrower tends to declare a lower value for the asset to dodge taxes. This, ironically, makes the loan safer, as the borrower is constrained to bring in more equity from the shadow economy.

In view of these differences, neither the FSB initiative on shadow banking nor the ?ring-fencing? of the Volcker, Vickers and Liikanen kind is very relevant for EMEs at this stage. Shadow banking is an extension of regulated deposit-based commercial banking to remote areas and to address the credit needs of those at the lowest end of the socio-economic spectrum where productivity levels are low, and who lack collateral to make them creditworthy. Shadow banking thus fulfils the role of traditional moneylending. In China, it currently also fulfils the role of development finance, as the government strains to keep banking credit in check without affecting growth.

Shadow banking in EMEs is closely monitored by regulators, something that is only now being attempted in AEs. Placing emphasis on opaque money markets, repo and securitisation markets?at the core of FSB?s efforts to rein in shadow banking?will not get such lending out of the shadows in EMEs, where productivity levels and property right frameworks need redressal.

Systemically important financial institutions (SIFIs) and resolution mechanisms. EMEs have very few global SIFIs, except China which hosts Bank of China (BOC) and Industrial & Commercial Bank of China (ICBC). There are concerns regarding their health due to rapid credit off-take since the GFC, because financial results are largely camouflaged and state controlled, and because of ICBC?s growing presence abroad and links with global markets.

EMEs have a number of domestic SIFIs, such as the State Bank of India and BNDES in Brazil, but these are mostly state-owned. Financial intermediation is regarded as a public utility committed to universal service through cross subsidies. Less attention is consequently given to putting in place mechanisms for orderly liquidation to avoid taxpayer bail-outs, as equity holders and taxpayers are mostly the same. Hence, it is difficult to envisage the need for any financial sector tax when the cost of intermediation is already high due to the public utility nature of financial intermediation.

EMEs have now realised that their exposure to global SIFIs means that capital may flow out in the event of a crisis in their parent countries or banks. The GFC led to a sudden stop of capital, with foreign banks in India exiting certain areas under stress, although global SIFIs like Citigroup, Deutsche and HSBC never ?pulled the plug? on their emerging market operations as such, and even provided some support and resilience during the crisis. Several EMEs are nevertheless considering ?ring-fencing? mechanisms to ensure that problems with the parent does not lead to withdrawal of capital from overseas branches, by incentivising wholly-owned subsidiaries over overseas branches.

To summarise, regulatory reforms in AEs hold little relevance for EMEs at this stage because their financial systems are fundamentally different. Financial systems in both need reform, but the challenges differ. EMEs have not actively engaged in the global debate on financial reform, but they now need to step up to the plate, after assessing its relevance and impact, instead of blindly assuming that their economies too should be financialised on the lines of the ?gold standard? of AEs.

(Concluded)

Alok Sheel & Meeta Ganguly

Alok Sheel is a civil servant and Meeta Ganguly is an independent researcher. Views are personal