Lax financial supervision in emerging markets can cost lives. "They're killing people in Albania right now because of a failure in financial regulation," says deputy US treasury secretary Larry Summers. Less dramatic than the Albanian pyramid savings debacle but equally troubling to the financial world and overstretched national budgets have been such events as the Mexican peso crisis, the collapse of Barings and lesser fiascos involving emerging market banks.
The IMF reported last year that more than 130 countries had experienced significant banking problems since 1980. Cleaning up the mess has cost more than 20% of GDP in some Latin American countries. It's estimated that emerging market governments have paid out more than $250 billion bailing out banks during the past 10 years. These problems seem bound to last for at least another decade. "The financial sectors, particularly the banking systems, in developing countries today are quite fragile," says Jonathan Fiechter, the World Bank's director of financial sector development. "I worry that development agendas will come to a screeching halt, particularly in countries that depend on capital inflows from abroad."
Local banking systems in emerging economies - a key link in cross-border capital flows - remain insular and backward, in many cases having been protected from foreign competition until recently. The arrival of strong foreign competitors and macroeconomic volatility - external and domestic - is expected to produce a stream of insolvencies.
It took the Mexican crisis to make G-7 officials take much note of banking problems outside their own countries. They first discussed them at the Halifax summit two years ago. Then in Lyons, last year, they directed finance ministries and central banks to come up with proposals for emerging market banking supervision in time for this month's Denver summit.
The G-7's own domestic regulatory systems are not without blemish - the Barings crisis, for example, may have involved developing-country markets but it was developed country supervision that ultimately was at fault. Nevertheless, three big studies that appeared in April - from the Basle Committee on Banking Supervision, the G-10 deputies (deputy finance ministers and senior central bank officials) and US academic Morris Goldstein - pick up on the call for closer supervision of developing-world financial systems. Issues raised in these reports are likely to be given serious attention in September at the World Bank and IMF annual meetings in Hong Kong.
Goldstein, a scholar at the Institute for International Economics in Washington, is reckoned to have prodded the international community towards considering a common approach. According to IMF deputy managing director Stanley Fischer: "The Basle committee [on banking supervision] initially told the IMF representative that a standard applicable beyond the G-10 [the largest industrial countries] would take about 10 years to develop and adopt." Fischer credits Goldstein with "mobilizing immobilizable institutions with a speed not seen in recorded history".
The Basle committee managed by April to produce a consultative draft entitled "Core principles of effective bank supervision". It should be finalized by September. Patrick Honohan, research professor at Dublin's National Economic and Social Research Institute, explains the initial hesitation, pointing out that "industrial-country bank regulators - who made up the Basle committee until recently - had put together a very complex package, politically speaking".
The current Basle capital standards balanced various national traditions and approaches to bank supervision. They set out a number of rules that did little violence to any of the traditions but provided a workable set of formulas for supervising international banks on a common basis. Were that model to be revised and extended to emerging markets there would be a risk of unpredictable problems being raised. The committee feared the earlier Basle agreement would be destabilized.
But there were also compelling reasons for the committee to act. The Bank for International Settlements - which provides a secretariat for the Basle committee - was interested in preserving its role after the creation of a European central bank. Meanwhile Bank supervisors worldwide were looking to the Basle committee for guidance. Then there was also a lot of pressure from the G-7 and the IMF. According to one official: "Members of the committee were told in no uncertain terms that if they wanted to become the pre-eminent body for bank supervisors worldwide they had to get going."
Universal agreement
The mix of caution and urgency meant the Basle committee produced another delicately balanced and politically complex report - on which there could be near universal agreement. Some observers describe it as mild. Others dismiss it as platitudinous. Others are puzzled by it. Roger Taillon, managing director for financial institutions ratings at rating agency Standard & Poor's, says: "It's a good start. But I wonder whether all of the supervisors who were involved in drafting the Basle report really subscribe to the overriding principles at the very beginning." (These set preconditions for effective supervision including clear responsibility, legal authority to address safety and soundness concerns, and operational independence.)
Goldstein is urging the Basle committee to strengthen the "core principles". He wants mechanisms built into them that reduce government involvement in the banking system. He also thinks American-style rule-based corrective action that is promptly applied needs emphasis. And he wants more specific guidelines for accounting, disclosure and provisioning. Finally, Goldstein faults the initial proposals on monitoring compliance - he is sceptical about the Basle committee's intention to conduct a survey by mail every two years that will rely on bank supervisors to rate their own systems.
Hard on the heels of the Basle committee report, the G-10 deputies released a broader study of principles for strengthening emerging market financial systems. These two projects are linked for one simple reason: the Basle committee is officially a G-10 group. Hal Scott, Nomura professor of international financial systems at the Harvard Law School, praises the G-10 report. "It focused on financial systems rather than just on banks," he says. "This is particularly important when everybody tells us that the world is moving from banking to capital markets. Another aspect of crisis prevention involves the payments system. The G-10 report gives some attention to that. It's promoting good practices. It's not an international banking standard. I have no problem with it because I don't think that it's coercive."