EAST ASIAN FINANCE The Road to Robust Markets Swati R. Ghosh EAST ASIAN FINANCE The Road to Robust Markets EAST ASIAN FINANCE The Road to Robust Markets Swati R. Ghosh ©2006 The International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org E-mail: feedback@worldbank.org All rights reserved. 1 2 3 4 5 09 08 07 06 This volume is a product of the staff of the International Bank for Reconstruction and Development / The World Bank. The findings, interpretations, and conclusions expressed in this volume do not necessarily reflect the views of the Executive Direc- tors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. 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All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail: pubrights@worldbank.org. ISBN-10: 8213-6743-9 ISBN-13: 978-0-8213-6743-8 eISBN: 0-8213-6744-7 DOI: 10.1596/978-0-8213-6743-8 Cover design by Drew Fasick. Cover image © Randy Faris/Corbis. Library of Congress Cataloging-in-Publication Data Ghosh, Swati R. East Asian finance : the road to robust markets / Swati R. Ghosh. p. cm. Includes bibliographical references and index. ISBN-13: 978-0-8213-6743-8 ISBN-10: 0-8213-6743-9 ISBN-10: 0-8213-6744-7 (electronic) 1. Finance--East Asia. 2. Financial institutions--East Asia. I. Title. HG187.E37G45 2006 332.1095--dc22 2006023145 Contents F O R E W O R D ix A C K N O W L E D G M E N T S x A C R O N Y M S A N D A B B R E V I A T I O N S xii Overview and Summary 1 The Changing Regional Context 1 Where Do the East Asian Financial Markets Stand Today? 3 The Road to Robust Markets 10 Conclusions 21 Outline of the Report 22 1 Moving Toward a More Robust and Diversified Financial System 25 2 Regional Cooperation as a Means to Diversify Financial Markets 29 Extent of Financial Integration 29 Enhancing Integration through Regional Initiatives 34 Both Regional and Domestic Policy Measures Are Needed 43 3 Building Better Institutional Infrastructure 45 The Exercise of Corporate Governance: An Overview 46 Shareholder Rights, Board Responsibilities, and Their Implementation 49 Creditors' Rights and Their Implementation 54 Accounting Standards and Practices 61 Summary 62 4 Fostering an Efficient and Sound Banking Sector 63 Developments in East Asian Banking Since the Financial Crisis 63 Improving the Efficiency and Enhancing the Reach of the Banking Sector 84 Ensuring the Stability of the Banking System 89 5 Deepening the Securities Markets 101 Developments in East Asian Securities Markets Since the Financial Crisis 101 Deepening the Securities Markets 109 Strengthening the Regulatory Framework for Securities Markets 122 Conclusions 126 6 Strengthening the Investor Base 129 Pension Funds 129 Insurance Sector 138 Mutual Funds 140 v vi Contents 7 Developing Sound Markets for Risk Sharing 149 Derivatives Markets 149 Securitization 157 8 Dealing with Growing Linkages Across Markets 169 Trends and Issues in Supervision 170 The Pros and Cons of Unified Supervision 171 Implementation Issues in Moving to Unified Supervision 172 A P P E N D I X E S Appendix 1: Statistical Tables 177 Appendix 2: International Financial Reporting 191 Appendix 3: Basel II Issues 195 E N D N O T E S 199 R E F E R E N C E S 209 I N D E X 213 B O X E S 1.1 Importance of a Diversified Financial System 25 2.1 Tests of Integration in Equity Markets 33 2.2 The Asian Bond Fund Initiative 36 2.3 Rationale and Feasibility of Setting Up a Regional Credit-Rating Agency 41 3.1 Key Elements for Well-Functioning Credit Information Systems 50 3.2 Summary of OECD Corporate Governance Principles 51 3.3 Selected Amendments to Corporate Governance in China's Company Law 52 3.4 Principles and Guidelines for Effective Insolvency and Creditor Rights 55 4.1 Reasons for the Expansion in Consumer Lending 70 4.2 The Hong Kong Mortgage Corporation 75 4.3 Cagamas: The National Mortgage Corporation in Malaysia 76 4.4 Progress in Corporate De-Leveraging and Corporate Performance 77 4.5 Impact of Structural Changes on Banking Sector Efficiency: Empirical Analysis 82 4.6 Effects of the Entry of Foreign Banks: Cross-Country Findings 87 4.7 Factors Affecting Availability of Bank Finance: Cross-Country Findings 90 4.8 Enhancing the Environment for the Provision of Microfinance by Banks 91 4.9 Deposit-Insurance System: Features of Good Design 93 4.10 Combating Money Laundering and Financing of Terrorism 96 5.1 Measures to Enhance Liquidity in the Domestic Bond Market in Malaysia 112 5.2 Trading Fixed-Income Instruments on the Exchange in Thailand 114 5.3 Repos and Securities Lending 116 5.4 New Ways for Medium-Size Companies to Access Capital: Mexico's New Securities Law 122 5.5 Demutualization: Corporatization of the Stock Exchange 123 6.1 In the Philippines, Outdated Legislation Is Delaying the Growth of the Investment Fund Sector 143 6.2 Collapse of Fixed-Income Funds in Korea in 1999 145 6.3 Enforcement Failure: Fixed-Income Funds in Indonesia 147 7.1 Main Features of Derivatives Markets 149 7.2 Failure of a Futures Exchange: The Shanghai Stock Exchange 152 7.3 Principles of Securitization 158 7.4 The KOROmas Fund Ltd. 160 Contents vii 7.5 The Bauhinia Program 160 7.6 Singa Secured Assets 161 F I G U R E S 1 GDP and Investment 2 2 Assets of the Financial Sector 4 3 Importance of Bank Assets Relative to Equity and Bond Markets 6 4 Efficiency of Equity Markets 8 5 Factors Affecting the Efficiency of Securities Markets 11 6 Insurance Penetration and Density 17 7 Structure of the Report 22 1.1 Assets of the Financial Sector 27 1.2 Importance of Bank Assets Relative to Equity and Bond Markets 28 1.3 Assets of Institutional Investors 28 3.1 Core Attributes and Underpinnings of Well-Functioning Financial Systems 46 3.2 Disclosure Practiced by Listed Firms 48 4.1 Indicators of Banking Sector Efficiency 66 4.2 Indicators of Banking System Soundness 66 4.3 Performance of East Asian Banks Relative to Those of Other Regions 68 4.4 Deposit-Money Banks' Claims on the Private Sector and Government 69 4.5 Size of Mortgage Debt 72 4.6 Residential Mortgage Markets in China 73 4.7 Indicators of the Reach of Banking Services 80 4.8 Degree of Competition in Banking 85 4.9 Regulations Affecting Ease of Entry and Exit 86 4.10 Schema of Different Banking Strategies and Bank Size 89 4.11 Compliance with Basel Core Principles for Banking Supervision 91 5.1 Number of Listed Firms 104 5.2 Proportion of Shares That Are Inaccessible to Foreigners 104 5.3 Equity Market Efficiency 108 5.4 Equity Market Stability 108 5.5 Factors Affecting the Efficiency of Securities Markets 110 6.1 Asset Class Exposure of Investment Funds 142 7.1 Liquidity Ratios in Equity Derivatives and Cash Markets 154 7.2 Participants in Key East Asian Derivatives Markets, 2004 154 7.3 Stylized Elements and Sequencing of Derivatives Markets Development 157 7.4 Composition of Cross-Border Securitization Deals 162 7.5 Mechanisms to Mitigate Credit and Structural Risks in More Complex Securitization 166 T A B L E S 1 Structure of Financial Systems 4 2 Bond Markets: Breakdown by Type of Bond Issuer 5 3 Liquidity Indicators in the Bond Markets 8 4 Market Infrastructure Scores 13 5 Factors Affecting Transaction Costs in Bond Markets 14 6 Main Over-the-Counter and Exchange-Traded Derivatives in East Asia 15 7 Assets of Institutional Investors 16 8 Indicators of Concentration in the Insurance Industry 18 9 Status of Key Elements Needed for Securitization 19 1.1 Structure of Financial Systems 27 2.1 Holdings of Foreign Assets and Liabilities with the Rest of the World 30 viii Contents 2.2 Consolidated Bank Claims 30 2.3 Portfolio Investment Assets and Liabilities 31 2.4 Correlation in Equity Returns 32 2.5 Correlation in Local-Currency Bond Returns 35 2.6 Regulations Affecting Cross-Border Flows 38 2.7 Tax Treatment of Returns from Foreign Investors' Holdings of Local Bonds 39 2.8 Availability and Access to Derivatives Markets for Cross-Border Investors 40 3.1 Corporate Governance Scores--A Market Perspective 47 3.2 Disclosure by Top Five Banks in Each Jurisdiction 49 3.3 Infrastructure for Credit Reporting and Financial Information 51 3.4 Assessments of Shareholder Rights and Board Responsibilities 52 3.5 Treatment of Real Property 56 3.6 Treatment of Movable Property 57 3.7 Assessment of Unsecured and Secured Creditor Rights 58 3.8 Assessment of Insolvency Regimes 59 4.1 Changes in the Structure and Ownership of Commercial Banks 64 4.2 Mortgage Rates Offered by Banks in Selected Economies 75 4.3 Predicted Shares of Households and Small Firms Using Banking Services 81 4.4 Measures of Consolidation and Diversification of Banking Sector Activities 82 4.5 Aspects of Deposit Insurance Schemes in East Asia 94 4.6 Main Features and Key Requirements for the Different Approaches Under Basel II 97 5.1 Size of Equity Markets (Market Capitalization) 102 5.2 Size of Bond Markets (Domestic Bonds Outstanding) 102 5.3 Indicators of Access to Stock Markets for Firms 103 5.4 Breakdown by Type of Bond Issuer 105 5.5 Liquidity in Equity Markets 106 5.6 Trading Costs in Equity Markets 107 5.7 Liquidity in Bond Markets 109 5.8 Where Countries Stand on Elements Affecting Pre-Settlement and Settlement Risks 115 5.9 Scores on Clearance and Settlement Infrastructure and Post-Settlement 115 5.10 Key Factors Affecting Liquidity and Efficiency of Securities Markets 117 5.11 Ratings of Securities Laws on Disclosure Requirements, Liability Standards, and Anti-Self-Dealing 121 5.12 Status of Demutualization 123 6.1 Assets of Institutional Investors 130 6.2 Asset Size and Type of the Most Important Pension Schemes 130 6.3 Broad Allocation of Pension Fund Assets 131 6.4 Coverage Ratios of Pension Schemes 132 6.5 Nominal Contribution Rates of Main Pension Schemes 134 6.6 Indicators of Development of the Insurance Sector 139 6.7 Indicators of Concentration in the Insurance Sector 140 6.8 Scope of Investment Regulations in the Life Insurance Sector 141 6.9 Governance Structures of Mutual Funds 143 7.1 Main Over-the-Counter and Exchange-Traded Derivatives 150 7.2 Derivative Products and Turnover 151 7.3 Status of Infrastructure for Derivatives Markets 156 7.4 Cross-Border Securitization Transactions 161 7.5 Status of Key Elements Needed for Securitization 164 7.6 Types of Risks in Securitization Transactions 165 8.1 Risk Transfers Among Banks, Insurance Companies, and Capital Markets 170 8.2 Advantages and Disadvantages of Different Models of Regulatory Structure 172 8.3 Major Implementation Issues Reported by Countries in Moving to Unified Supervision 173 8.4 Average Time Taken to Complete Key Tasks in Moving to Unified Supervision 174 Foreword East Asian financial markets have witnessed major transforma- tions since the 1997 financial crisis. Most striking has been the resolution of banking and corporate sector distress. Banks have been recapitalized, and a significant consolidation has taken place in the banking sectors in the region. At the same time, govern- ments have taken a range of initiatives to strengthen the regula- tory foundations of the financial sector, including improved prudential regulations and supervision and corporate governance and disclosure standards. East Asian governments have also come together to launch several regional initiatives aimed at harness- ing the potential for regional integration and minimizing the risks of contagion. Against this backdrop, in consultation with policy makers and market participants in the region, the World Bank identified a need to take stock of what has been achieved in the region and the priorities for the financial sector going forward. East Asian Finance: The Road to Robust Markets provides the empirical foun- dation for the discussions and benchmarks of the financial mar- kets in East Asia. The report has benefited from broad-based engagement with policy makers and institutions in the region. Six institutions in the region--the Asian Institute of International Financial Law (Hong Kong University), Cagamas Berhad (Housing Corporation of Malaysia), the Hong Kong Mortgage Corporation, the Korea Institute of Finance, the Rating Agency of Malaysia, and the Secu- rities Commission of Malaysia--have collaborated on this work and have contributed a series of papers on selected issues; these are included on the CD at the back of this report. This Selected Issues volume will also be made available on the World Bank Web site. Aspects of this report were discussed at two workshops held in November 2005; one with the APEC Finance Development Center in Shanghai and another with the Korea Institute of Finance in Seoul. The report has also benefited from a major conference that the World Bank organized with the Hong Kong Monetary Authority entitled "East Asian Financial Markets; the Next Frontier," which brought together policy makers and private sector experts in the region in June 2006. ix x Foreword Looking ahead, a well-functioning financial supervision. The report reviews these challenges sector will be critical to meeting both the large and the implications for appropriate risk sharing financing requirements and the demand for more and risk transfer. sophisticated financial services. In the past, the East Asian policy makers are focusing on re- financial sector focused largely on the needs of gional integration as an important means for devel- corporations. But as per capita incomes rise, the oping and diversifying financial markets and for financial sector will face growing demands from expanding the opportunities for financial inter- consumers, especially for finance for housing and mediation in the region. The report argues that other durables. At the same time, businesses in the there are synergies to be exploited between these region are looking for a broader range of services, regional-level initiatives and the domestic policy including investment banking services. And with agenda. In particular, the development of the the deepening of intra-regional trade, firms that bond markets--important for financial market operate across borders will likely require cross- diversification--will rest on a combination of the border financial services. Catering to these needs initiatives being taken at the regional level and calls for further progress toward more diversified, measures to develop the institutional investor base efficient, and robust financial markets. The report at the domestic level. reviews the agenda to achieve these objectives In comparison to other regions, East Asian through a detailed examination of all the key seg- financial markets today are developing at a rapid ments of the financial system and of the institu- pace. It is encouraging to see the importance that tional infrastructure. policy makers attach to the agenda for financial sec- The report highlights the importance of tor development and to see their commitment in strengthening risk management in financial institu- translating strategies and ideas into specific actions. tions across the financial segments. Globally the tra- We look forward to partnering with the region in ditional separation among banking, insurance, and addressing the remaining challenges. securities markets is breaking down as a result of The CD attached to this report also includes technological innovations, deregulation, and liber- comparative data on the key financial segments of alization. Financial intermediaries now offer prod- the countries in the region, based on a new dataset ucts that resemble those traditionally offered by that is being developed by the World Bank. other intermediaries. The securitization of tradi- tional forms of credit and new ways of repackaging and trading risks is weakening the distinction between equity, debt, and loans. And new products Homi Kharas are also giving rise to new linkages across financial Chief Economist and Sector Director intermediaries and markets. These developments East Asia and the Pacific Region pose challenges for risk monitoring, regulation, and The World Bank Acknowledgments This volume is a contribution by the World Bank to the ongoing dialogue on financial sector development in East Asia. It has benefited from extensive discussions with policymakers, regula- tors, and market participants. The report was written by Swati Ghosh, with contributions from Loic Chiquier, Ismail Dalla, Oliver Fratzscher, Gregorio Impavido, Luc Laeven, Jose Luna Martinez, Cedric Mousset, Diego Sourrouille, and Craig Thorburn; it also draws on inputs by Thorsten Beck, Inessa Love, Sjamsu Rahardja, and Liza Valen- zuela. Several other World Bank staff provided valuable support, including Ernesto Revilla, Marco Arena, Vidhi Chhaochharia, Claire Grosse, Ruogu Huang, Zubaidur Khan, Margaret Miller, Ronald Points, Jong-ku Choi, Antonio Ollero, Gyeongsoo Bae, Sameer Goyal, Behdad Nowroozi and Stefano Curto. Support for document processing was provided by Gloria Elmore. Special thanks are due to Amar Bhattacharya, Stijn Claessens, and Marilou Uy, who provided guidance and feedback from the inception of the study to its completion. Latifah Merican also pro- vided valuable guidance. The support received from Jemal-ud-din Kassum (Vice President, East Asia and Pacific Region, until November 2005) is also much appreciated. The study has also benefited from papers on selected issues prepared by our counterparts. These papers are in the volume East Asian Finance: Selected Issues and can be found in the attached CD. We would like to express our gratitude to the Asian Institute of International Financial Law (University of Hong Kong); Cagamas Berhad, Malaysia; the Hong Kong Mortgage Corporation; the Korea Institute of Finance; the Rating Agency of Malaysia; and the Securities Commission of Malaysia. The support of the Hong Kong Monetary Authority is also gratefully acknowledged. The report was prepared under the overall guidance of Khalid Mirza (Sector Manager, East Asia and the Pacific Region), Homi Kharas (Chief Economist and Sector Director, East Asia and the Pacific Region), and Jeff Gutman (Acting Vice President, East Asia and the Pacific Region). xi Abbreviations and Acronyms ABF1 Asian Bond Fund 1 FXTN Fixed Treasury Note ABF2 Asian Bond Fund 2 GSCS Name of private company ABMI Asian Bond Market Initiative IAS International Accounting Standards ADB Asian Development Bank IBNR International Financial Reporting AIM Alternative Investment Market Standards AMA Advance Measurement Approach IFRS International Financial Reporting Standards APEC Asia-Pacific Economic Cooperation IGAAP International Generally Accepted ASEAN+3 Association of Southeast Asian Nations Accounting Principles (plus China, Japan, and the Republic of Korea) IOSCO International Organization of Securities Commissions BCBS Basel Committee on Banking IPO Initial Public Offering Supervision KTB Krungthai Bank BCP Basel Core Principles LSE London Stock Exchange BIS Bank for International Settlements MFI Micro-Finance Institutions BOT Bank of Thailand MGS Malaysian Government Securities BSP Banko Sentral ng Pilipinas NBFI Non-Bank Financial Institution CBRC China Banking Regulatory Commission NPA Korean National Pension CDO Collateralized Debt Obligation Administration CGFS Committee on the Global Financial NPC Korean National Pension Corporation System NPL Non-performing loan CLSA Credit Lyonnais Securities Asia OECD Organisation for Economic CSD Central Security Depository Co-operation and Development CGT Capital gains tax ORSO Occupational Retirement Schemes DVP Delivery Versus Payment Ordinance EFB Exchange Fund Bills OTD Over the counter EFN Exchange Fund Notes PAIF Pan Asian Bond Index Fund EMEAP Executive Meeting of East Asia Pacific QFII Qualified foreign institutional investors ERM Exchange Rate Mechanism SA Standardized Approach ETD Exchange-traded derivatives SEC Securities and Exchange Commission F-IRB Foundation Internal Ratings Based SFC Securities and Futures Commission Approach (HK) FSA Financial Services Authority UKLA United Kingdom Listing Authority FSDI Financial Sector Development UNICTRAL United Nations Commission on Indicators International Trade Law FSS Financial Supervisory Services WHT Withholding tax xii Overview and Summary This volume seeks to con- The Changing Regional Context tribute to the important Over the past eight years, some significant developments have taken discussion on the agenda place that are changing the context in which countries in the region are operating. These developments emphasize both the need for, for financial sector develop- and the possibility of, more efficient intermediation and stronger ment that is now under- more diversified financial systems in the region. way among policymakers One such important development has been the accumulation of substantial international reserves, which now amount to more and market participants in than US$1.6 trillion. This high level of reserves reflects not only East Asia.* Developments the resumption of capital flows to the region--as East Asia has once again become the largest recipient of international flows-- since the financial crisis of but also the accumulation of the region's own savings. These re- 1997, as well as some of sources will allow the region to meet its financing needs over the the lessons of the crisis next few years. At the same time, as the financial crisis highlighted, there are also challenges in intermediating large capital inflows itself, have prompted effectively without making economies more vulnerable. policymakers in East Asia Looking ahead, both financing requirements and the demand for financial services are likely to expand, making it important to to take a strategic look at achieve efficient financial intermediation. Corporate financing the role that the financial needs are likely to rise over the next few years. Though recent eco- sector needs to play in nomic growth has been strong, averaging 5.6 percent a year during 2000­052, much of it has stemmed from exports and private con- the region's ambitious sumption (Figure 1). Investment has generally been weak and er- agenda for growth ratic; except in China, the average investment rate, at around 25 and development. percent of GDP during 2000­04, remains significantly below the pre-crisis average of 34 percent of GDP (1993­96). The fall in the investment rate has been especially large in Indonesia, Malaysia, and Thailand. Countries' efforts to improve the investment climate can be expected to raise productivity, but the region is still likely to have sizable needs for investment, including in infrastructure. A wider range of financial services will also be needed. In the past, the financial sector focused largely on the needs of corpora- tions. But as per capita incomes rise it will face growing demands *The report covers China, Hong Kong (China) (SAR), Indonesia, Korea, Malaysia, the Philippines, Thailand, and Singapore, and for brevity refers to this set of economies as the East Asia region. China is covered in less depth than the other economies, given the very distinct set of issues pertaining to its financial markets. 1 2 East Asian Finance FIGURE 1 GDP and Investment a. Contribution to GDP growth, 2000­ 05 (average) b. Investment 8 50 private consumption investment average 1993­96 average 2000­04 public consumption net exports 6 40 tnecr 4 P 30 DGfo pe 2 % 20 0 10 3.8 5.1 5.2 3.7 5.0 5.7 3.9 ­2 0 sia nes ina sia sia nes lay ailand , China apore Ch lay ailand , China apore Indone p. of Korea sia Ma Philippi Th Sing Indone . of KoreaMa Th p Philippi Sing Re Kong Re Kong Hong Hong Source: World Bank, East Asia Update 2006. Note: Numbers under columns in figure 1a denote GDP growth, 2000­ 05. from consumers, especially for finance for housing more diversified financial systems in order to increase and other durables. Moreover, businesses in the re- the risk-bearing capacity of the East Asian econo- gion are looking for a broader range of services, in- mies.5 Some of the concrete measures that have been cluding investment banking services. Meanwhile, taken at the regional level in this context address intra-regional trade is deepening and firms that ope- what may be termed demand-side constraints (from rate across borders will likely require cross-border fi- the perspective of investors), while others address nancial services. supply-side issues (from the perspective of issuers). Another important development in the regional Under the Executives' Meetings of East Asia Pa- context is the growing attention to regional coopera- cific Central Banks (EMEAP), two Asian Bond Funds tion. Several regional arrangements and cooperative have been launched using a portion of EMEAP's frameworks existed before the crisis3, and various international reserves. The first of these, the Asian initiatives for regional financial cooperation have Bond Fund 1 (ABF1), pooled $1 billion of reserves emerged since then. There are two areas in particular and invested in US dollar-denominated government where measures have been taken at the regional level. and quasi-government bonds of eight ASEAN+3 The Chiang Mai Initiative, established in May countries. The second (ABF2), of US$2 billion, is 2000, is a network of bilateral currency swap agree- investing in local-currency-denominated sovereign ments among 13 ASEAN+3 countries, designed to and quasi-sovereign bonds. Its aim is to give both prevent currency crises in the region. In May 2005, retail and institutional investors access to local bond the finance ministers of these countries announced markets in the region in a transparent and cost- their intention to move to a collective or synchro- effective manner, and it is being enlarged through nized activation of bilateral swaps. The group also private placements by institutional investors, par- agreed to institute a more comprehensive mandatory ticipating dealers, and market makers. surveillance mechanism for all ASEAN+3 members.4 ABF2 should also provide an impetus to broader Initiatives to develop a regional bond market have market development in two ways. First, like ABF1, by been the second area of regional cooperation, as the being an actual fund it has allowed policymakers to crisis brought to the fore the importance of having learn from experience and has helped to identify crit- Overview and Summary 3 ical impediments to cross-border listing and invest- Much of the focus of policymakers therefore needs ing. Second, it is expected to spur the introduction of to be on domestic policy measures, while recogniz- new instruments for investors: since the construc- ing the synergies that can potentially be obtained tion of the index and the compilation methodology from undertaking regional measures in tandem with will be published, managers of private funds can use these domestic measures. these indexes as benchmark indexes and replicate or customize these for their fixed-income products. Where Do the East Asian Financial Working groups under ASEAN+3 and Asia-Pacific Markets Stand Today? Economic Cooperation (APEC) have addressed some of the supply-side constraints on cross-border invest- As is now well recognized, a vibrant East Asian finan- ments, including the issuance of new securitized debt cial sector of the future will need at least three char- instruments; credit guarantee and enhancement acteristics. It will need to be highly diversified to mechanisms; foreign-exchange transactions and set- meet the financial services requirements of increas- tlement issues; the issuance of bonds denominated in ingly complex and sophisticated economies. It will local currency by multilateral development banks, need to provide financial services efficiently, con- foreign agencies, and multilateral corporations; and tributing to the productivity and competitiveness of local and regional credit-rating agencies. the economy as a whole. And it will need to be ro- While regional cooperation is providing an im- bust, to able to withstand a range of shocks in a fast- petus toward achieving more diversified financial changing globalizing world economy. This section markets, many of the needed policy measures will therefore looks at where financial markets in the have to be undertaken at the domestic level. This is region stand with regard to these aspects. because the necessary deepening and diversification of markets largely depends on actions at the domes- How diversified are the financial markets? tic level and also because the benefits of the regional initiatives themselves depend on the complemen- Over the past eight years, the region's financial sec- tary development of domestic markets. tor has deepened, with significant growth of assets Indeed, while regional initiatives have helped iden- in banking and in equity and bond markets (Table 1 tify and remove several of the direct barriers to cross- and Figure 2). At US$9.6 trillion in 2005, the assets border bond investments, cross-border bond flows of the East Asian financial markets were equivalent (especially within the region) remain quite small. to about 21 percent of the U.S. financial market and Partly this reflects differences among countries in almost half of that of Japan. areas such as credit-rating standards, legal and regula- Measured in terms of market capitalization, East tory systems, and accounting and auditing standards Asia's equity market has tripled since 1997, amount- and practices; these differences add to costs and un- ing to US$2.3 trillion in 2004 and US$2.8 trillion in certainty for both issuers and investors and can deter 2005. Stock markets in the region are still consider- cross-border flows. Partly, too, it reflects the fact that ably smaller than in the United States, the United the region's institutional investor base is still quite Kingdom, or Germany, and in aggregate still account small. The regulatory, governance, and risk-manage- for only 6 percent of world stock market capitaliza- ment frameworks of institutions such as pension tion. But in relation to the size of domestic economies funds and insurance companies need to be strength- they compare very favorably with those of advanced ened to ensure these institutions have the incentive industrial countries. Indeed, stock market capitaliza- and ability to undertake cross-border investments. tion as a percentage of GDP is larger in Hong Kong Domestic derivatives markets also need to be further (China), Singapore, or Malaysia than in the United developed and deepened, because limitations in this States, United Kingdom, or Germany. regard can reduce investors' interest in cross-border The region's bond markets have also seen sizable investments. All these measures and actions need to be growth over the past six or seven years, albeit with con- undertaken at the domestic level. At the same time, of siderable variation across countries. In the region as a course, regional financial integration can significantly whole, bonds outstanding amounted to US$1.4 tril- enlarge the gains from domestic policy measures, and lion in 2004 and US$1.5 trillion in 2005. However, indeed, in some cases can make the development of much of the growth in bond markets (and more than domestic financial markets more viable. 50 percent of the growth during 1997­2004 in all 4 East Asian Finance TABLE 1 Structure of Financial Systems (percent of GDP) Bank assets Equity market capitalization Bonds outstanding Economy 1997 2004 2005 1997 2004 2005 1997 2004 2005 China 124.6 176.4 163.1 11.2 23.1 17.8 12.9 24.9 24.4 Indonesia 31.1 14.6 49.8 12.2 28.8 28.9 1.9 22.6 19.6 Rep. of Korea 37.9 130.1 93.5 8.1 57.1 91.2 25.2 83.3 76.2 Malaysia 100.9 169.0 159.4 93.2 153.3 138.0 57.0 90.0 88.0 Philippines 56.1 66.5 63.2 37.7 33.0 40.4 22.4 28.4 36.7 Thailand 79.7 129.2 103.6 15.1 71.4 70.1 7.1 41.1 40.8 Hong Kong 205.1 337.5 444.6 234.5 519.5 593.6 26.0 46.3 46.6 (China) Singapore 122.0 176.8 185.4 110.8 202.3 220.4 24.7 73.1 68.2 Sources: International Monetary Fund International Financial Statistics (IMF IFS), Bank for International Settlements (BIS), Asian Development Bank (ADB) Asian Bonds Online, and World Bank staff calculations. economies in the region except Hong Kong (China) equity, and even bond markets.7 And given their per and the Republic of Korea) has been on account of capita incomes and the extent of their financial deep- bonds issued by governments, largely to restructure ening overall, countries in East Asia lag behind in the banking systems (Table 2). Although corporate importance of their bond markets, particularly of the bonds have accounted for a reasonable proportion corporate bond market, relative to the other finan- of the growth in several jurisdictions, in most they cial segments (Figure 3). remain quite a small proportion of the overall bond market.6 How well are financial markets Across the world, countries' financial structures serving a broad set of needs? vary widely. But compared to countries in other re- gions with broadly comparable per capita incomes, To what extent are the financial sectors in the region those in East Asia have relatively large banking, serving the needs of consumers and firms through the FIGURE 2 Assets of the Financial Sector (percent of GDP) a. Financial sector assets, 1997 b. Financial sector assets, 2004 1,200 1,000 bonds bonds 1,000 equities 800 equities banks banks 800 GDP 600 of 600 400 percent 400 200 200 0 0 ina sia rea sia es re s ain key ina rea sia s ilippine, ChinahailaSing nd e s ain key Ch Indone. of KoMaPhilippin lay , Chinahailandgapod StateMexico Sp r r Tu Ch lay xico Sp Tu T T apord StateMe p Sin ite Ind . of onesiaKo Ma p Ph ite Re Kong Un Re Kong Un Hong Hong Source: Asian Bonds Online, BIS, IFS and WFE, WDI and World Bank Financial Structure Database. TABLE 2 Bond Markets: Breakdown by Type of Bond Issuer 1997 (% of GDP) 2004 (% of GDP) Contribution to growth 1997­2004 (%) Economy/region Government Corporate Financial Government Corporate Financial Government Corporate Financial China 7.5 0.7 4.7 14.8 0.6 9.5 60.7 ­0.3 39.3 Indonesia 0.4 0.8 0.7 20.1 1.5 1.1 94.6 3.1 2.3 Rep. of Korea 4.9 10.3 10.0 25.2 23.3 34.9 34.9 22.3 42.8 Malaysia 19.4 20.8 16.8 38.2 38.0 13.9 56.7 52.0 -8.8 Philippines 22.3 0.1 0.0 28.7 0.1 0.0 100.3 ­0.3 0.0 Thailand 0.2 6.0 0.9 22.4 12.3 6.4 65.2 18.6 16.2 Hong Kong 7.4 18.5 0.0 9.5 36.8 0.0 10.3 89.7 0.0 (China) Singapore 13.6 11.2 0.0 41.2 32.4 0.0 56.6 43.4 0.0 Sources: ADB, BIS, and country sources. Overview and Summary 5 6 East Asian Finance FIGURE 3 Importance of Bank Assets Relative to Equity and Bond Markets a. Bank assets to stock market capitalization b. Bank assets to bonds outstanding 8 8 China Hong Kong, China China 6 6 tio 4 tio 4 ra ra Thailand Philippines Singapore Philippines Rep. of Korea 2 2 Malaysia Thailand Rep. of Korea Malaysia Singapore Indonesia Hong Kong, China Indonesia 0 0 0 10 20 30 40 0 10 20 30 40 per capita GDP per capita GDP Source: Asian Bonds Online, BIS, IFS and WFE, WDI and World Bank Financial Structure Database. different financial segments? In banking, the ratio to region have broadened. For their part, however, banks GDP of domestic credit extended to the private sec- may have become more risk-averse; pre-crisis lending tor has yet to recover to pre-crisis levels in several of levels were not necessarily the appropriate ones, given the crisis-affected countries--notably Indonesia, the that corporations in most countries depended heavily Philippines, and Thailand--suggesting that banks are on bank loans and were overly leveraged. still holding many of their assets in forms other than Over the next few years, demand for corporate fi- loans (notably government bonds). In Indonesia and nancing is likely to increase in line with investment the Philippines, government assets held by banks needs. Continued improvements in information constitute around 15 percent of GDP. disclosure and in overall corporate governance in Of the domestic credit that banks have extended to the corporate sector, together with improvements in private borrowers, a growing share has gone to con- banks' capacity to evaluate risks, will be important sumers. In 2004, consumer lending accounted for in ensuring the resumption of bank lending to cor- 53 percent of total bank lending in Malaysia, 49 per- porations on a sustainable basis. cent in Korea, 30 percent in Indonesia, 17 percent in Equity markets have provided another source of Thailand, 15 percent in China, and 10 percent in the financing for firms. For the region as a whole, new Philippines. The bulk of these loans to consumers has equity raised in the capital markets (from initial pub- been for housing, although other forms of lending, no- lic offerings) amounted to US$32 billion in 2004 and tably credit-card lending, have also grown fast. Even US$31 billion in 2005. so, several countries still have substantial scope for The role of equity markets varies widely across greater penetration of banking services to households. countries in the region, however. Those in Hong Kong Lending by banks to the corporate sector has re- (China), Singapore, Korea, and Malaysia play an im- mained muted. In part this reflects low demand, both portant role, and those in the other countries have the because corporate investment has remained low and potential to play a much more important role than because firms have deleveraged and financed a signif- they do at present. In this latter group of countries, the icant proportion of their capital needs through re- amounts of equity raised are still quite small, as is the tained earnings. Firms have also sought alternative number of listed firms, and a high proportion of stock sources of external finance as financial markets in the market capitalization and trading is accounted for by Overview and Summary 7 the top ten firms. (Relative to countries at the same per outsource their non-core operational functions with capita income levels in other regions, the Philippines, a view to achieving greater operational efficiency. For Indonesia, and Thailand are all doing well.) example, four foreign banks have set up regional As noted above, corporate bond markets are still processing centers in Malaysia. relatively small in most of the countries in the region, On average, banks in East Asia have become more and could play a greater role in corporate financing efficient over the past few years.8 Several of the struc- than they do at present. The key reason for the small tural changes that have taken place, including the corporate bond markets is the lack of liquidity in sec- strengthening of capitalization and foreign owner- ondary markets. A shortage of liquidity in secondary ship, seem to have helped improve banking sector markets matters not only for efficiency, as discussed performance and efficiency. below, but also for the overall size of the market, be- However, banks in the region have yet to realize cause there is a two-way interaction between the size the potential economies of scale and scope from the of the primary market and liquidity in the secondary consolidation that has taken place. Larger banks and market. Investors are generally willing to invest in se- banks that pursue a broad range of activities per- curities only if there is enough liquidity for them to sell form less efficiently than smaller banks and special- and exit easily when needed. And, if liquidity is low ized banks. This may be because it takes time to and price discovery does not function well, the in- learn how to reap the benefits of consolidation, and vestors that do participate will generally demand a for many banks in the region it may be too early to higher interest rate or return to compensate for the low see the results of this learning process. But it is also liquidity, and this in turn may further deter companies important to recall that most of the consolidation from listing on the stock exchange or issuing bonds. that has taken place so far has been government-led. If consolidation is to be accompanied by improve- ments in performance, the banking systems in the How efficient are the financial systems region need a competitive environment within which in the region? to operate. Significant structural changes have taken place in the Comparisons with countries at similar per capita banking sectors of the crisis-affected countries, in income levels outside the region suggest that East response to policymakers' efforts to address issues Asia's equity markets have room to improve their of capitalization, governance, risk management, and efficiency (Figure 4).9 Hong Kong (China), Korea, operational inefficiencies in the aftermath of the cri- Malaysia, and Singapore have the most efficient mar- sis. These efforts included closures and consolidation kets in the region--although Korea ranks in the third of banks, often entailing initial nationalization fol- highest quartile and the remainder rank only in the lowed by re-privatization. As a result, most countries median range of a global sample of 85 economies. in the region have seen a sizable rise in the foreign In the bottom quartile are Thailand, Indonesia, the ownership of banks, as well as significant consolida- Philippines, and China. tion and an increase in the average size of banks, In some countries in the region, a sizable propor- measured in terms of both assets and deposits. tion of shares remains inaccessible to cross-border Consolidation has also taken place in the banking investors. As of end-2004, foreign investors had no sectors of Hong Kong (China) and Singapore, which access to around 42 percent of the stock market in the were not directly affected by the crisis. Here, as in Philippines, 41 percent in China,10 and 36 percent in other advanced industrialized economies, the trend Thailand.11 This, coupled with the fact that in some has been driven by competitive pressures arising economies a sizable proportion of shares is closely from deregulation (domestic and foreign) and tech- held (around 28 percent in China, 30 percent in nological advances. Indonesia, 40 percent in the Philippines, and 21 per- Most countries in the region have eased their re- cent in Thailand), means that in some cases only a strictions to allow banks to conduct business in areas small percentage of shares is freely available to would- such as securities and insurance. Banks are respond- be investors. In turn, this can significantly dampen ing, to varying degrees, by offering fee-based services the liquidity and efficiency of a stock market. in new areas, and some are beginning to form strate- As noted above, the biggest constraint on the de- gic alliances with other financial institutions and to velopment of the region's bond markets is the limited 8 East Asian Finance FIGURE 4 Efficiency of Equity Markets Composite measure of efficiency of equity markets 8 Mexico United States 6 United Chile Russian e Spain Kingdom Rep. of Hong Kong, Federation orcs Korea China Malaysia Turkey dezidrad Singapore 4 Japan Thailand Indonesia an st Philippines 2 China 0 Source: World Bank, Financial Sector Development Indicators (FSDI). liquidity in the secondary markets--which affects the of advanced industrial countries, and, not surpris- efficiency of these markets overall. Of course, liquid- ingly, liquidity is even lower in the corporate bond ity in bond markets is limited even in the advanced market (Table 3). Corporate bonds are generally industrial countries. Nonetheless, the region's bond much smaller than government bonds and their small markets on average are much less liquid than those issue size contributes to illiquidity. TABLE 3 Liquidity Indicators in the Bond Markets Turnover ratio (%) ABF2 Bid-ask spread Value traded (US$ billions) Government (basis points) and quasi- Economy Government Corporate Government Corporate sovereign Government China 568.6 1.4 2.2 12.0 55.2 n.a. Indonesia 27.7 0.9 0.6 0.2 102.0 14.3 Rep. of Korea 952.2 382.2 3.3 1.0 610.4 2.5 Malaysia 84.3 38.1 1.8 0.8 135.6 4.3 Philippines n.a. n.a. n.a. n.a. 33.9 n.a. Thailand 70.1 5.6 2.0 0.3 228.7 6.3 Hong Kong 542.4 n.a. 34.7 n.a. 623.1 2.4 (China) Singapore 130.5 n.a. 3.2 n.a. 535.5 3.2 Japan 29,964.2 1,139.6 5.4 0.9 n.a. 2.0 Canada 6,428 n.a. 30.6 n.a. n.a. 0.7 Germany 6,600 n.a. 10.1 n.a. n.a. 0.2 United 6,516 n.a. 14.2 n.a. n.a. 0.5 Kingdom United States 103,829 n.a. 37.9 n.a. n.a. 0.4 Sources: Value traded, turnover ratios, and bid-ask spreads for Asian economies: ADB Asian Bonds Online and Newsletter 2004. Asian Bond Fund 2 (ABF2) turnover ratio: International Index Company, September 2005. For OECD countries, value traded and turnover ratios are from Debt Management and Gov- ernment Securities Markets, and bid-ask spreads from ADB Newsletter, except for Canada and Germany, data for which are as of 2006 from World Bank FSDI. Notes: n.a. = not available Overview and Summary 9 What is happening to risk and stability? seems to have improved as banks have transferred parts of their traditional credit risks to capital mar- Banking sectors in the region are sounder on average kets. But while risks can be intermediated and dis- than they were a few years ago and their health is tributed more efficiently, they may simply become steadily improving. In all the formerly crisis-affected less visible as they move into less regulated segments countries, the reported nonperforming loan ratios are of the financial markets. now in single digits, reflecting gradual improvements Two major potential risks in East Asian financial in profitability in the economies. Banks' capital posi- markets today--that policymakers need to be cog- tions have also improved and in all countries the nizant of--are that higher risks will become con- average reported risk-weighted capital-adequacy centrated in public banks and that risks will be ratios are now significantly above the 8 percent rec- aggressively shifted to less sophisticated non-bank ommended by the Bank for International Settlements. financial institutions. Nonetheless, there is considerable variation across In general, weaker banks have incentives to carry banks as well as across countries in the region. More- larger risks, partly because implicit safety nets such as over, on average, East Asia's ratio of nonperforming deposit insurance tend to subsidize the pricing of loans remains high relative to that in other regions risks. Public banks are usually tasked with carrying such as Latin America or Emerging Europe, while larger and lumpier credit risks, often to serve national its profitability and risk-weighted capital-adequacy development goals. Meanwhile, most advanced pri- ratios are slightly lower. vate banks have begun selling undesirable credit risk In general, East Asia's securities markets are rela- in order to reduce risk-capital charges (since capital tively stable compared with those of other regions.12 charges will be risk-based under the Basel II Capital Among a sample of 100 economies worldwide, Adequacy Framework, which most jurisdictions in Singapore falls in the highest (most stable) quar- the region have said they plan to adopt). Weaker tile, followed by Hong Kong (China), China and banks, as well as public banks that do not always op- Malaysia in the second-highest quartile. Indonesia, erate under risk-based frameworks, may be tempted the Philippines, and Thailand fall in the bottom to buy this credit risk in order to boost their rev- quartile, as does Korea. Cross-country analysis sug- enues. If credit risk is being redistributed within the gests that inadequate disclosure of information can banking system, there is a possibility that larger risks make it more likely that an equity market will be un- are being concentrated in weaker and public banks, stable and deliver large negative returns.13 Hence, although they may not be visible as long as credit continued improvements in disclosure should help spreads remain at their current record-low levels. to make the region's equity markets more stable. Some transfer of risks may also be taking place in What about the risks and stability of the financial the more weakly regulated non-bank financial insti- systems as a whole? In principle, a diversified finan- tutions. The growth of modern risk-transfer tech- cial system, with appropriately developed markets niques is confounding the traditional assumption and mechanisms for risk sharing and risk transfer, that banks face credit risks, mutual funds market such as securitization and derivatives, can enhance risk, and insurance companies liquidity and maturity the risk-bearing capacity of an economy as a whole, risk. Customized risk transfer from banks to non- by enabling market participants to manage and trans- banks is made easier by the sophisticated slicing of fer risks to those more able and willing to bear them. risk (with so-called real or synthetic collateralized Risk transfer through new financial instruments obligations of debt, or loans or assets). Although data has been a major innovation globally. Global de- are scarce, market observers confirm that banks are rivatives markets have grown extremely fast: over- net sellers of credit risk and insurance companies are the-counter derivatives markets have grown tenfold net buyers. over the past decade to reach US$248 trillion, while Little information is available about the quality exchange-traded derivatives markets have grown to of credit-risk management in non-bank financial in- US$53 trillion in 2004. stitutions or about the potential credit risk in insur- Derivatives markets in the East Asia region have ance or re-insurance companies, especially within accounted for a sizable proportion of this growth, East Asia. However, concerns have been expressed and the stability of the region's financial systems about the limited understanding of non-bank risk 10 East Asian Finance exposures, about regulatory arbitrage contributing pacity of the economies. Strengthening the elements to risk-shifting, and about the ultimate risk takers needed to develop securities markets, including in- being the most weakly regulated institutions. struments and markets for risk sharing, and their institutional underpinnings will also advance the development of robust financial systems overall. The Road to Robust Markets While the development of securities markets will Sizable transformations have taken place in financial help to broaden the structure of the financial sys- systems in the region since the crisis. Banks have been tems and should contribute to risk diversification restructured and recapitalized, many have been and overall risk reduction in the economies, there is consolidated, and on average, they are now sounder. also the possibility that inappropriate risk transfer Countries have made efforts to upgrade prudential will take place through the use of derivative instru- regulation and supervision, although some areas need ments and other means--with risks being shifted further strengthening.14 toward segments and institutions that have weaker At the same time, as noted above, there is still risk-management capacity and are weakly regulated. scope for broadening access to banking services to This possibility requires a more proactive stance on households and for continuing to enhance the effi- the part of supervisors to improve the monitoring of ciency of banks that have started to provide a range risks and the supervision of these institutions. of income- and fee-based services. Equity markets could play a more important role than they do at Developing securities markets present in several countries in the region, while the potential role of bond markets is even greater since As noted above, there is a two-way interaction be- corporate bond markets are still relatively small. tween the size of a securities market and its liquidity Thus, despite the considerable progress that has and efficiency. Limited liquidity is the key issue in the been made, countries in the region face a broad- East Asian securities markets, particularly the bond ranging agenda in the financial sector: markets. Three main factors affect (and are reflected in) further strengthening the efficiency, access, and liquidity or the lack of it: the availability of informa- soundness of the different segments of the finan- tion to price securities accurately; transaction costs; cial system; and the size and heterogeneity of the investor base developing sound markets and instruments that (Figure 5). To enhance the efficiency of the securi- will enable market participants to share and ties markets, policymakers will need to address each transfer risks to those most able and willing to of these factors. bear them; continuing to improve the institutional underpin- Improving the informational basis nings of the financial sector (the exercise of cor- for pricing securities porate governance and information disclosure, Timely and accurate information is very important the legal and regulatory framework, and account- for liquidity; based on such information, liquidity ing and auditing standards and practices); can be generated by the activity of investors who dis- promoting a more diversified financial system. agree about fundamentals, facilitating the process of price discovery. The task that will help the most to advance the In improving the informational basis for pricing agenda as a whole is the further development of the securities, a fundamental element will be the con- securities markets. Despite the progress made in di- tinued strengthening of corporate governance and versifying the financial structure in recent years, the of information disclosure. Among the crisis-affected financial systems of the East Asian countries are still countries, Korea and Malaysia, followed by Thai- dominated by banks. The development of securities land, have moved the furthest in reforming their markets, especially the bond markets, will be impor- laws and regulations and practices. In Indonesia and tant both to cater to the needs of savers, investors, the Philippines there is still considerable scope to and corporate borrowers and to diversify the finan- strengthen corporate governance. More recently, cial structure and hence enhance the risk-bearing ca- China has also begun to strengthen corporate gov- Overview and Summary 11 FIGURE 5 Factors Affecting the Efficiency of Securities Markets EFFICIENCY OF SECURITIES MARKETS C variety of Liquidity investor bases A B information to transaction price accurately costs (explicit-- taxes, commission, fees--and implicit) For bonds: · benchmarks · credit rating · PDs, intermediaries Corporate governance Market infrastructure Complementary & mechanisms infrastructure · shareholder rights · repo markets · creditor rights trading forms · securities lending, · disclosure standards & practice pre-settlement · margin trading including · accounting and auditing ­ trade confirmation T+1 or less short selling clearance and Settlement · derivatives markets ­ central counterparty ­ real time gross settlement or netting ­ CSD ­ dematerialized ­ final settlement by T+3 ­ DVP Source: Author. Note: shaded ovals indicate important areas that could benefit from further strengthening. ernance. It is important to continue to raise aware- take place at arm's length and are properly autho- ness of good corporate governance principles and rized and adequately disclosed. It is also important practices among companies, directors, sharehold- that minority shareholders have mechanisms to seek ers, and other interested parties in the region. redress if their rights are violated. At present, deriv- Broadly, the key challenges with respect to corpo- ative actions are rare and class action laws do not rate governance lie in ensuring the effective exercise of exist in some jurisdictions. minority shareholder rights, in improving financial Further efforts are needed to strengthen the reporting and disclosure, and in strengthening the oversight of boards of directors and to improve rule of law. In many, if not most, cases, the legal and the effectiveness of audit committees. Under good regulatory requirements on information disclosure, corporate-governance principles, boards are expected shareholder and creditor rights, and accounting and to act in good faith, with due diligence, and in the auditing standards are in place. But implementation best interests of the company and the shareholders. and enforcement are often weak, because regulators They are also expected to fulfill certain key functions lack sufficient independence, skills, or resources. including selecting, compensating, monitoring, The rights of noncontrolling (minority) share- and replacing key executives; ensuring a formal and holders need to be protected against expropriation transparent board-nomination process; and moni- by controlling shareholders or insiders (managers). toring and managing potential conflicts of interest Since there is an inherent conflict of interest here that of management, board members, and shareholders. needs to be managed, mechanisms are needed to At present, the concept of fiduciary duty is not ex- ensure that transactions between firms and insiders plicit in many countries and directors are not often 12 East Asian Finance held accountable for failing in their duties. Since the would need to move away from price-controlled financial crisis, a high priority has been placed on bond auctions. Benchmark bond issues must also countries in the region to restructure corporate be large and stretch across the maturity spectrum. boards, including mandating outside directors and Countries in the region have attempted to build various committees (to be responsible for nomina- benchmark yield curves in government bonds since tion, remuneration of directors and management, 1998. And though Hong Kong (China) and Sing- and audit). Often, though, ostensibly independent apore have succeeded in building both short and directors do not adequately challenge or probe the intermediate yield curves (for up to 15 years), in judgment of managers. Finally, the concept of audit other economies, liquidity in issues with a maturity committees is new, and often these committees are of more than five years is limited. China has no not effective. benchmark yield curve yet. The use of primary- As regards information disclosure, though listed dealer systems can help to promote greater liquidity companies across the region adhere to the regular in government benchmark issues, and aspects of reporting of their financial results, there is still con- these systems need strengthening in several coun- siderable room for improving the prompt disclosure tries in the region. of market-sensitive information and for strengthen- A second important element for corporate bond ing the scope and content of disclosure, particularly pricing is the existence of good credit-rating agen- in China, Indonesia, and the Philippines. It is clearly cies. Rating agencies play a very important role in important that firms disclose all material informa- helping to determine the credit risk and thus the tion, rather than practicing the somewhat selective spread pricing of corporate bonds. Although rating disclosure that is a common choice. Most countries agencies exist in all the countries covered in this re- have put in place disclosure-related rules and regu- port, and their penetration in domestic markets is lations for listed companies. What is needed is to en- relatively high, several of them are quite new and force these rules and to cultivate a culture of greater need more time to build a track record. International disclosure over time. rating agencies, for their part, rate only the compa- The quality of financial reporting and disclosure nies that issue across borders. Some of these agencies depends on accounting and auditing standards and have formed joint ventures with local rating agen- practices. East Asian countries are at different stages cies, but difficulties in comparability across countries of convergence toward international standards, but can still hamper cross-border investments. where these standards are not yet followed, full dis- closure of this fact would promote greater investor Reducing transaction costs confidence. Enforcing financial standards is also im- Transaction costs comprise explicit trading costs-- portant. For high-quality financial reporting, man- such as commissions, settlement fees, and taxes--as agers of firms need to have the incentive to take the well as implicit costs--which represent the opportu- steps needed to comply with applicable accounting nity costs of delaying or not executing a trade. A mar- standards in preparing financial statements; auditors ket with high transaction costs will see less trading need to be able and willing to fulfill their professional and have fewer price movements in response to rele- obligations; and regulators need to have the legal vant news and therefore be less liquid and less effi- authority and capacity to monitor financial report- cient. The factors that affect explicit and implicit ing and auditing practices and to enforce applicable transaction costs include withholding taxes and fees, accounting and auditing standards. the efficiency of the intermediaries, market infra- In bond markets, accurate pricing can be facili- structure and institutional arrangements, and "com- tated with several additional infrastructural com- plementary" infrastructure. ponents. First, there is the need to be able to price East Asia's securities market infrastructure is rel- corporate bonds with reference to a "risk-free" atively well developed (Table 4). Almost all countries benchmark (or index interest rate)--mostly com- in the region possess advanced clearing and settle- monly the interest rate of a government bond. To be ment systems with the recommended features to a valid comparator, the price of a government bond minimize the risks (including the potential opportu- must be truly driven by supply and demand. For this nity costs of delayed or failed trade) that are associ- to happen in China, for instance, the authorities ated with pre-settlement and settlement of securities. Overview and Summary 13 TABLE 4 Market Infrastructure Scores Economy GSCS benchmark clearance and settlement score Post-settlement score China 92.5 A- Indonesia 68.5 A Rep. of Korea 97.3 A+ Malaysia 93.3 A+ Philippines 92.4 A Thailand 93.6 A Hong Kong (China) n.a. A+ Singapore n.a. AA- Memorandum Greece 85.0 A+ Japan n.a. A+ Mexico 90.5 A+ Peru 97.8 A- Turkey 98.3 A Venezuela, R.B.de 72.6 BBB Sources: GSCS and Thomas Murray. Note: GSCS compares the settlement efficiency of markets, incorporating average trade size, local-market interest rates, the proportion of trades that fail, and the length of time for which they fail. Thomas Murray produces ratings of post-trade risk exposures according to various criteria of clearing and settlement, safekeeping, and asset servicing. The ratings follow a standard alpha scale from AAA to C. Going forward, these systems will need to expand to growth, often doubling every two or three years (col- handle substantially larger volumes of transactions. umn 4); commodity derivatives, which have a long East Asian countries vary more in their "comple- history, especially in China (although commodity mentary" or supporting infrastructure--that is, in derivatives account for less than 10 percent of the the development of repo (repurchase) markets, secu- turnover of the exchanges); and credit derivatives. rities lending, margin trading (in particular, short Among the fastest growing products are credit deriv- selling), and derivatives (Table 5). Lack of these in- atives, especially credit-default swaps, which account struments and facilities reduces liquidity and increases for about half of the OTC market. the transaction costs of trading, and is an area that It is estimated that about 10 percent of the world- these countries now need to focus on. wide US$6 trillion credit-derivative market is located Derivatives, provided they are developed within in Asia, mainly in Tokyo and Hong Kong (China). an appropriate framework of solid product design, However, the bulk of derivatives activity overall is at regulation, and sound market infrastructure, and present limited to a few economies in the region, used in the context of good corporate governance notably Hong Kong (China), Korea, and Singapore and sound risk management within the financial in- (Table 6). stitutions, can play a very important role in allowing To further develop the derivatives markets in East market participants to manage and transfer risks to Asia, cross-country experience suggests the following those better able and willing to bear them.15 needs. First on the list are efficient, liquid, and inte- Five main derivatives products are traded in East grated cash markets (for bonds, equities, commodi- Asian markets. These are: foreign-exchange prod- ties, and other assets) that are broadly determined ucts, in which the region is estimated to account by market forces rather than administered prices. for 15 percent of the global market (Table 6, col- Administered interest rates, segmented fixed-income umn 1); interest-rate derivatives, in which the re- markets, and capital controls make it unlikely that gion accounts for less than 2 percent of worldwide markets for interest-rate or foreign-exchange deriv- trading on the over-the-counter (OTC) market and atives can develop successfully. slightly more than 2 percent of the exchange-traded The second need is for a suitable legal and regula- derivatives (ETD) market (columns 2 and 3); equity tory framework. In many emerging markets, includ- derivatives, which have witnessed the most rapid ing in East Asia, exchange-traded derivatives have 14 East TABLE 5 Factors Affecting Transaction Costs in Bond Markets Asian Hong Kong Finance Transactions costs China Indonesia Korea Malaysia Philippines Thailand (China) Singapore Withholding taxes CGT: 5%. CGT: 20%. CGT: The lower CGT: None. CGT: None CGT: 15%. CGT: None. CGT: None. WHT on WHT on of 11% of gross WHT on for transactions No CGT on WHT on WHT on interest Interest sales proceeds interest on the exchange. government interest interest income: 10% income 20%. or 27.5% of net income: WHT on bonds or income: income: for QFII. Other tax: capital gains. None. interest certain quasi- None. None for 0.1% of gross WHT on income: 20% government government sale proceeds interest bonds. WHT and certain is withheld by income: 27.5% on interest quasi- the broker as income: government income tax for None for bonds. securities government transactions or executed on government- the exchange. guaranteed debt; 15% otherwise. Repo markets Planned in Underdeveloped Underdeveloped Relatively Underdeveloped Underdeveloped Mature repo Mature repo 2007a so dealers but available developed. but available but available market market Available for unable to short with tenors Available with with overnight, with maturities government from overnight maturities 14 and 30 days. up to 6 months. bonds 7 days to 90 days up to 1 year. to 1 year. Margin purchases - margin purchase allowed? Nob Yes Yes Yes Yes Yes Yes Yes - margin loans allowed? Nob Yes Yes Yes Yes Yes Yes Yes - margin purchases practiced? No Yes Yes Yes Yes Yes Yes Yes Short sales - short sales allowed? Nob Yes Yes Noc Yes Yes Yes Yes - stock lending allowed? Nob Yes Yes No No Yes Yes Yes - short sales practiced? No No Yes No No No Yes Yes Notes: CGT = capital-gains tax. WHT = withholding tax. QFII = Qualified foreign institutional investors. a. Repo markets in China are available for government bonds but not enterprise bonds. b. The new amendments to the securities law in China leave open the possibility of margin trading but do not specify purchases or sales. c. Malaysia has just announced a partial lifting of the ban on short sales that was imposed during the crisis. Short selling will be limited, however, to fewer than 100 stocks out of the nearly 1,000 listed. Overview and Summary 15 TABLE 6 Main Over-the-Counter and Exchange-Traded Derivatives in East Asia (US$ billion) Over-the-counter Over-the-counter Exchange-traded foreign-exchange interest-rate interest-rate Exchange-traded Economy derivatives derivatives derivatives equity derivatives Singapore 91 9 42 3 Hong Kong 70 11 1 4 (China) Rep. of Korea 10 1 13 50 Other East Asia 8 4 1 8 % total of world 15 1.8 2.1 3.7 Sources: BIS Triennial Central Bank Survey, 2004; WFE Annual Report and Statistics, 2005. grown strongly and involved a mix of banks, securities other settlement systems. Therefore, a CCP is ex- firms, and institutional as well as retail investors. pected to have several safety cushions, including Hence, regulators have adopted a more function- adequate capital and effective margin rules. based approach to regulating derivatives markets, rec- Bearing these issues in mind, experience suggests ognizing that such trading may pose higher risks for that there is merit in developing deep and liquid cash retail investors as well as for systemic stability. Indeed, and repo markets first, followed by many of the many regulators have expressed a policy preference to derivatives products that trade primarily on the ex- channel derivatives trading out of the unregulated change-traded derivatives market. To promote safety OTC markets toward regulated ETD markets--which and soundness, the development of the more com- have additional safety features, since every trade re- plex over-the-counter products should probably not quires a prior cash deposit for margins that limit lever- be sought until a later stage (unless these products age. Strong coordination among regulators (local emerge spontaneously to fulfill a need). Index futures authorities, securities regulatory authority, central are often among the first products to be introduced-- bank, and finance ministry) is critical to close any before options on individual assets or more tailored loopholes and ensure that rules are strictly enforced. and innovative OTC derivative products, such as There is also a need to enact a derivatives law that pro- credit-default swaps. tects netting arrangements (see Chapter 7) in bank- ruptcies and enables effective enforcement. Broadening the investor base Third, to provide a level playing field between To foster greater liquidity and efficiency in the secu- OTC and ETD derivatives, capital rules for banks rities markets, countries in the region also need to operating in the OTC markets need to be aligned enact measures that can help broaden and diversify with the margin rules that govern the ETD markets. the investor base. It is important to have a wide, The development of derivatives markets also calls heterogeneous investor base with different prefer- for certain key elements of institutional infrastructure, ences and risk appetites. Thus, in addition to the con- notably good accounting standards and disclosure-- tractual savings industry (pensions and insurance), including the adoption of mark-to-market modalities countries will need to further develop a mutual fund as required under International Accounting Stan- industry that can cater to retail investors, whose dard 39--and of market infrastructure. The single needs and risk appetites may be even more hetero- most important means to manage risk in derivatives geneous. Also important in attracting a wide variety markets is to reduce exposure through close-out of investors is the ability to provide different types of netting arrangements, ideally with a central counter- products to suit the different risk preferences of in- party (CCP) that interposes itself between the vestors16 and to foster greater integration by opening counterparties to financial contracts that are traded up and facilitating cross-border investments. in one or more markets. However, because a CCP The assets of East Asia's institutional investors also concentrates risks, it requires effective risk con- have grown over the past few years and now amount trols, financial resources, and oversight, because a to around 45 percent of GDP in the region as a failure could spill over to payments systems and whole. Clearly though, the size of assets varies across 16 East Asian Finance TABLE 7 Assets of Institutional Investors Pension Life insurance Mutual funds Total US$ % of US$ % of US$ % of US$ % of Economy billions GDP billions GDP billions GDP billions GDP China 28.0 1.6 136.0 7.9 27.0 1.6 191.0 11.1 Indonesia 5.4 2.1 10.5 4.2 11.1 4.5 27.0 10.9 Rep. of Korea 161.0 21.4 133.0 17.7 186.0 24.7 480.0 63.8 Malaysia 70.0 59.2 21.0 17.8 23.0 19.4 114.0 96.4 Philippines 7.9 9.2 2.7 3.1 1.4 1.6 12.0 14.0 Thailand 20.0 12.0 17.0 10.2 19.0 11.4 56.0 33.6 Hong Kong 38.0 22.9 9.0 5.4 465.6 280.3 512.6 308.6 (China) Singapore 68.0 61.2 33.0 29.7 28.0 25.2 129.0 116.0 Total East Asia region 398.2 11.8 362.2 10.8 761.0 22.6 1,521.7 45.2 Sources: Hong Kong and Shanghai Banking Corporation (HSBC) 2005, Dalla 2005, Bank Negara Malaysia (BNM), Bank of Thailand (BOT). Note: Figure for mutual funds in Singapore only includes Singapore dollar funds domiciled in Singapore. countries, with the institutional investor base still these pension schemes are relatively immature, being a very small percentage of GDP in China, and their need for investment instruments is still Indonesia, and the Philippines (Table 7). quite small. Pension schemes. The pension schemes of the Even at their current asset size, the region's pen- region differ widely in their institutional design, sion funds could contribute more to capital-market coverage, maturity, benefit provision, value of assets development if they were to invest a greater share of under management, and asset allocation--all of which their assets in securities. What reforms could be bear directly on the actual and potential impact of undertaken that would both advance the goals of pen- pension funds on the development of capital markets. sion funds and simultaneously encourage a greater use The conservative investment regulations generally of capital markets? observed in the region are typical of those governing In defined-benefit schemes, the adoption of an public pension schemes in emerging economies.17 asset-liability framework would likely encourage But, by and large, the actual allocations of pension greater investments in securities. Managers of such funds tend to be even more conservative than the reg- schemes have traditionally focused on investment ulations permit. Other than in Hong Kong (China), management, managing their assets against a return where pension assets are largely held in equities, in benchmark for an asset class. However, since defined- most countries they are mainly invested in govern- benefit schemes have predetermined liabilities or ment securities and bank deposits. obligations, the focus is better placed on liability Pension assets in the region are still relatively benchmarking--in which a liability index is con- small. The Singaporean Central Provident Fund and structed and assets and liabilities are managed with the Malaysian Employees' Provident Fund have as- regard to the correlation between the two. sets that exceed 50 percent of GDP, but since both For defined-contribution schemes, an argument these schemes also have mandates unrelated to pen- could be made for increasing the annuitization sions, the amount of assets effectively connected to component. This would improve both the inter- the pension function is smaller than might appear. and intragenerational risk-sharing properties of Pension funds in the other countries amount to less the pension system. From the perspective of capital than 25 percent of GDP. And although Korea, the market development, increased annuitization would Philippines,18 and Thailand have national defined- strengthen the potential impact of the pension sys- benefit schemes (which, in view of their long-term tem by enlarging the set of professional institutional liabilities, may be expected to have the strongest investors and the demand for long-duration fixed- demand for longer-dated fixed income securities), income securities. Overview and Summary 17 Allowing or encouraging pension funds to invest (Table 8)--in part because the legal minimum capi- a greater proportion of their assets in securities will tal levels for entry into the industry are low by inter- require strengthening their governance structures national standards. The small size of these companies and their risk-management systems. These are still prevents them from playing an important role in the relatively weak in many countries in the region. capital markets. Insurance. What of the (life) insurance sector Several jurisdictions in East Asia are moving to in- in East Asia, whose assets have grown quite rapidly troduce risk-based capital requirements in the insur- over the past few years but remain relatively small? ance sector. In turn, this is likely to enhance insurance Looking ahead, the potential importance of this companies' risk management skills and allow coun- sector for capital market development will depend tries to move to less restrictive investment regimes. more on the size of assets than on changes in invest- Focusing on capital regulations will also likely lead to ment regulations, because in general the latter are not consolidation of the industry in those countries that binding. currently have a large number of small companies, Future growth in the assets of the insurance sector enabling the industry to play a larger role in capital will, of course, depend on the scope for further devel- markets. oping the industry's coverage and products. Penetra- Mutual funds. At the end of 2004, East Asia tion ratios--measured as the insurance premium as a accounted for about 10 percent of the US$16 trillion percentage of GDP, and density ratios--measured as global net asset value of mutual funds. Both Hong the premium per capita, show a still-substantial scope Kong (China) and Singapore have set out to be re- for further growth, particularly in China, Indonesia, gional centers for asset management,19 and unlike the the Philippines, and Thailand (Figure 6). other countries of the region they derive a large pro- A potentially important impetus to capital market portion of their assets from abroad. After Hong Kong development might come from a consolidation of the (China) and Singapore, mutual funds in relation to insurance industry. In several countries in the region, the domestic economy are largest in Korea and including Indonesia, Malaysia, the Philippines, and Malaysia (20 and 25 percent of GDP respectively), Thailand, the industry consists of many small players followed by Indonesia, China, and the Philippines. FIGURE 6 Insurance Penetration and Density a. Insurance penetration ratios b. Insurance density ratios 10 2,500 non-life non-life life life 8 P $S 2,000 DGfo U at 6 %sa piacrep 1,500 4 1,000 ium merp ium 2 merp 500 0 0 ina sia sia nes ina sia sia nes Ch of Korea Ma lay ailand , China apore Ch of KoreaMa lay ailand , China apore Indone Th Th Rep. Philippi Kong Sing Indone Rep. Philippi Sing Hong ng Kong Ho Source: Swiss Re, various issues. 18 East Asian Finance TABLE 8 Indicators of Concentration in the Insurance Industry Herfindhal index Economy Year Life Non-life China 2004 1,803 3,684 Indonesia 2004 811 478 Rep. of Korea 2004 1,846 1,622 Malaysia 2003 1,683 460 Philippines 2004 1,439 424 Thailand 2004 2,527 439 Hong Kong (China) 2005 926 229 Singapore 2004 1,989 588 Source: World Bank staff estimates. Note: The Herfindhal index is defined as the sum of squares of the market shares of each individual firm. It ranges from 0 (competitive or equally distributed) to 1 (monopolistic or dominated by one firm). Alternatively, it can range from 0 to 10,000, if percents are used as whole numbers (e.g. 75 instead of 0.75). World Bank comparisons across markets suggest that a Herfindhal index value of around 1,200 to 1,500 would be the natural range for non-life insurance markets, and because of greater economies to scale and lower concerns of risk aggregation, around twice that level for life insurance. Mutual funds have grown rapidly in most coun- easily than laws, but they remain governed by the key tries in the region, albeit starting from a small base. principles set out in the law. Hong Kong (China) and Growth was above 20 percent during 2003­04 in all Singapore have followed this approach. countries except Thailand, and was fastest in China Second, establishing and maintaining investor and Indonesia (89 percent and 49 percent respec- confidence. Several aspects are important in this re- tively).20 As exemplified by Indonesia in 2005, how- spect, including: having a clear definition of the legal ever, this growth has not always taken place in a form of the fund; imposing a clear and primary duty sustainable manner. on the managers of funds and custodians to act in Clearly a wide range of investment products, with the interests of fund investors; ensuring that the different investment objectives and strategies, are rights of investors are well defined; ensuring equi- available to retail investors in Hong Kong (China) table treatment of incoming, ongoing, and outgoing and Singapore. Korea also offers a wide range. The investors in open-ended funds through valuation, variety of fund products in China, Indonesia, pricing, and issue- and redemption rules; ensuring Malaysia, and Thailand is still relatively limited, adequate disclosure to investors; having unambigu- although many new collective investment products ous rules identifying different categories of funds, have been introduced in recent years. and taking steps to avoid any portfolio abuses. The region's experience points to some key ele- Third, ensuring that regulations are enforced. In ments that need to be put in place to develop the ensuring the stability--and hence ultimately the sus- mutual fund industry on a sound basis: tained development--of the mutual fund industry, First, ensuring an appropriate and flexible regu- enforcement of the rules and regulations in an equi- latory framework. While financial markets innovate table manner is important. constantly, laws are difficult and time-consuming to change. In some countries, for example the Philip- Developing instruments that appeal pines, outdated legislation has hindered the devel- to a broader set of investors opment of the mutual fund industry. While laws Securitization, which entails transforming illiquid governing mutual funds are needed to provide a assets into securities that can be traded on securities clear legal basis for fund operation and regulation, it markets, can provide an important mechanism for is preferable that they deal only with issues of prin- sharing risks--in particular, credit risks.21 For in- ciple and leave the details to subsidiary legislation. vestors, securities offer yields that exceed those on To accommodate changes such as new forms of comparable corporate bonds and provide diversifi- funds, or to allow for new investment powers such cation into a different form of investment. Securiti- as derivatives, regulations can be adapted more zation therefore broadens the investor base because Overview and Summary 19 it caters to investors with different risk/return ap- is to be able to ensure a true sale--that is, the irrev- petites who are willing to bear incremental credit, ocable transfer of assets to an insubstantive special- prepayment, and liquidity risks in return for a higher purpose vehicle to which the asset seller has no ties yield. And for originators, such as corporations, asset of ownership or control.22 The transaction must with- securitization provides a new and potentially cheaper stand any legal claim in bankruptcy against the asset form of financing. seller (bankruptcy remoteness). Securitization is increasingly being used for a In general, the elements of law that are typically wide variety of purposes--ranging from facilitating associated with securitized transactions in advanced access to capital markets for small and medium-size markets, involving existing or future claims origi- enterprises and the transfer of credit risk from banks nated by financial intermediaries, are present in to capital markets, to the transfer of both banks' and the three common-law jurisdictions--Hong Kong non-bank financial institutions' mortgage loans to (China), Malaysia, and Singapore. The civil-law capital markets. In East Asia thus far, most of the se- countries (China, Indonesia, Korea, the Philippines, curitization activity has taken place in Hong Kong and Thailand) have all introduced, or plan to intro- (China), Korea, Malaysia, and Singapore, although duce, enabling laws that to different extents permit a few deals have taken place in Thailand and in the the creation of securitized transactions recognized Philippines. by international standards. But, except in Korea, Securitization requires that certain legal, regula- where the relevant laws are well established and tory, and accounting elements be in place. In par- actively used, these laws have yet to be tested either ticular, it requires legislation that allows for the by a large number of transactions or in conditions creation, transfer, and perfection of ownership in- of stress or challenge. terests (Table 9). While the details vary among ju- While securitization offers strong potential ben- risdictions, a generic requirement for securitization efits for originators and investors and can be an TABLE 9 Status of Key Elements Needed for Securitization Creation, maintenance Sale, assignment or other conveyance of assets by and operation of special- originators to securitization vehicles purpose vehicle Other Legal framework Restrictions Default and Restrictions on for creating, on types foreclosure Legal and securitization transferring or terms and/or regulatory vehicles to and of financial Taxation repossession impediments issue multiple perfecting assets that and gain at level of e.g., Taxation or tranches ownership can be recognition individual bankruptcy licensing with varying Economy interests transferred issues assets remoteness requirements characteristics China 1­2 1 1 1 1 1 1 Indonesia 2­3 2 2 2 2 2 2 Rep. of Korea 5 4 3­4 4 5 5 5 Malaysia 5 4 4 3­4 4 4 5 Philippines 2­3 2­3 1­2 2­3 2­3 2­3 2­3 Thailand 3­4 3 3­4 3­4 2­3 4­5 2­3 Hong Kong 5 5 4 5 5 5 5 (China) Singapore 5 5 5 4 5 5 5 Source: Arner and others 2006. Notes: Score 1 (lowest) to 5 (highest). Scores such as 2­3 represent an intermediate appraisal between two given levels. These split scores are intended to reflect degrees of uncertainty as to commercial outcomes. There are contractual restrictions as to the transfer of financial claims in all review markets, except generally in Hong Kong (China) and Singapore. The table includes no appraisal of national accounting standards. It makes no attempt to summarize regulatory restrictions on investors, which may have just as great an impact on the early stages of market development. Such restrictions have traditionally been widespread, and only those in Hong Kong (China), Korea, and Singapore have been subject to relaxation since 2000, in relation to both the professional and retail segments. 20 East Asian Finance important means of risk transfer, it also introduces at present there are only international and national risks of its own which, in turn, require the develop- rating scales. ment of risk-management instruments and the pres- Policymakers in the region may therefore wish ence of reliable counterparts. Since the nature of to consider the pros and cons of establishing a re- the risks can vary depending on the type of securiti- gional credit-rating agency. Such an agency could zation, there may also be an argument for sequencing ensure that an assigned rating would denote the the more complicated forms of securitization in line same probability of default in any East Asian coun- with the development of the requisite market players try; it could provide more finely graded credit rat- and derivatives markets. Thus, even if simple securi- ings than are now available on a regional scale; and tization can be implemented, it may be more appro- it could help smaller companies to acquire ratings priate for some countries to wait to pursue the more for their international issuances (to the extent that complicated, tranched securitization deals involving there is cross-subsidization). It could also help to complex credit risks, foreign exchange risks, and in- develop capabilities for assessing credit risk across terest rate risks, because to reduce these risks requires the region and to provide the necessary training for many different market players and risk-management the national rating agencies to speed the conver- tools. Without these tools, risks are often substantially gence of standards across the region. higher in some forms of securitized products. Thus in The merit of setting up a regional credit-rating promoting securitization in the region, it is important agency would hinge critically on (1) the growth of for countries to keep in mind the need to also develop cross-border issuance and investments over the next the derivatives markets. five to ten years, and (2) the credibility that such an agency could establish for itself. This, in turn, would depend on the governance structure that is estab- Harnessing gains from integration lished. In particular, the shareholder structure would Although regulations prohibiting or restricting capital need to follow certain key principles: shareholders inflows and outflows have been progressively reduced would need to be seen as credible and fostering in- (and except in China, are now fairly minimal), several dependence of operations; shareholdings would need other factors continue to impede cross-border trans- to be widely dispersed (and fortified by a strong acting in East Asia's bond markets. These include shareholders' agreement); the maximum sharehold- withholding taxes; the lack of hedging instruments; ing would need to be limited to say 5­10 percent, and differences in market practices and infrastructure unless the shareholder were an independent third (for example, in the extent of documentation needed, party such as a rating agency or multilateral agency; trading platforms and conventions, procedures for and a balanced regional representation in the share- clearance and settlement and custodian systems, or holding structure would be essential. settlement of foreign exchange trades); as well as in credit rating, legal and regulatory systems; and ac- Ensuring appropriate risk-sharing counting and auditing standards. These factors need and risk transfer to be addressed--and, as noted above, several of them are being dealt with by ASEAN+3 working groups. As noted above, it is possible that risks will be shifted A key building block of a bond market is the in a manner that is not evident, from stronger pri- assessment of credit risk. From the perspective of vate banks to public banks and from banks to the cross-border investments, however, there are several more weakly regulated non-bank financial institu- issues. First, although the three big international rat- tions. Such players may not adequately assess and ing agencies operate in the region, these rate only a manage the risks they are taking on. Strengthening small number of Asian firms and financial institu- the corporate governance of these institutions is tions that issue in international markets; hence the clearly of paramount importance. So are proactive smaller companies do not get rated.23 Second, the measures by regulators and supervisors to better standards of national rating agencies differ widely, monitor risks and to strengthen supervision on a making it difficult for foreign investors to assess in- consolidated basis. vestment possibilities. Third, no finely graded ratings Globally, the traditional separation among bank- within the region are available to potential investors; ing, insurance, and securities markets is breaking Overview and Summary 21 down as a result of technological innovations, de- However, arguments can also be made against uni- regulation, and liberalization. Financial intermedi- fied supervision. First, a mega-regulator may become aries now offer products that partly resemble those excessively bureaucratic in its procedures and slow to traditionally offered by other intermediaries.24 The react to emerging problems. Second, the effectiveness securitization of traditional forms of credit (such as of supervision may be compromised if a new inte- mortgages, credit-card receivables, and commercial grated agency fails to develop a consistent framework loans) and the proliferation of increasingly sophis- of regulation and supervision for the financial sector. ticated ways of building, repackaging, and trading While a certain degree of harmonization of super- risks, are weakening the distinction between equity, visory practices across the banking, insurance, and debt, and loans (such as through the creation of securities supervisors is desirable to reduce regulatory hybrid instruments). The development of new prod- arbitrage, it is important to recognize that the partic- ucts is giving rise to new forms of linkages across ular characteristics of each industry require specific financial intermediaries and markets. And com- regulations. It should also be noted that if the super- petition is spurring different types of financial vision of financial markets is poor under separate intermediaries to merge, producing large financial entities, it will still be poor under a unified regime, un- conglomerates that provide a broad range of services less weaknesses in regulation and supervision are across the financial segments. effectively addressed. Finally, if the process of merging These developments pose challenges for risk is not managed properly, it may result in the departure monitoring, regulation, and supervision. In response of experienced personnel and the demoralization of to these challenges, a number of countries world- the rest of the staff, affecting the overall supervisory wide have started to examine how they regulate and effectiveness during the transition period. supervise financial intermediaries. Some, including Korea and Singapore, have Conclusions adopted so-called unified or integrated supervision, in which a single agency is responsible for supervis- As is now well recognized in the region, there is a need ing the entire financial system. But the prevailing to focus on further developing the securities markets model in the region is one of multiple supervisors, in and the corporate bond markets in particular. which at least one agency supervises banks, another A key constraint in the bond markets is the lack of oversees securities firms, and a third oversees insur- liquidity, which affects efficiency and the overall role ance companies. Economies with multiple super- these markets are able to play. To enhance liquidity visors include China, Hong Kong (China), Indonesia, in the bond markets, non-bank financial institutions the Philippines, and Thailand. need to develop further, both in asset size and in- Countries that have adopted unified supervision stitutional sophistication. These institutions can play have done so in the belief that a single supervisor can an important role in mobilizing and channeling long- be more effective than multiple supervisors in mon- term resources through securities markets to meet itoring the soundness of individual financial insti- the financing requirements of corporations as well as tutions as well as the vulnerabilities of the entire those of housing and infrastructure projects. The financial system. In particular, they believe that uni- further development of the bond markets will also fied supervision allows them to better understand and require efforts to strengthen information disclosure monitor risk transfers among different financial inter- and the exercise of corporate governance, and their mediaries and market segments; to better assess the institutional underpinnings. Since many of these real and potential impact of industry- and market- elements are important for the robust functioning wide issues, such as market turbulence, that affect the of the financial markets more generally, addressing financial system; to better understand the cross- them will help to advance the broader agenda of sectoral nature of the business of financial conglomer- financial sector development. ates; to more easily develop policies toward the risks Greater integration of securities markets, espe- affecting a financial conglomerate as well as its single cially of bond markets, across national borders could entities; and to use a consistent approach to monitor- also yield strong benefits. Bond markets in individ- ing similar financial products and services, regardless ual East Asian countries have been too small and of what type of financial institution provides them. fragmented to fully benefit from the economies of 22 East Asian Finance scale that are generally associated with successful corporate governance of financial institutions, as bond market development. Thus, regional coopera- well as the ability to monitor and supervise these tion to remove some of the remaining impediments institutions, will be key in this regard. to cross-border investments can be very useful. And creating regional financial products, such as regional Outline of the Report index funds, will further facilitate investment within the region. Chapter 1 reviews developments in the financial sys- Concurrent actions at the domestic level are es- tems of the region and emphasizes the importance of sential if the full benefits of regional cooperation are efforts to strengthen and diversify these systems, and to be reaped. For instance, not only does the still- Chapter 2 describes progress and issues in regional narrow base of institutional investors need to be financial integration, emphasizing the complemen- developed at the domestic level, but if significant tarity between the needed regional and domestic cross-border investment is to take place, differences policy reforms. Subsequent chapters look at the do- in credit-rating standards, in legal and regulatory mestic measures needed to further develop the finan- frameworks, and in accounting and auditing stan- cial markets. Chapter 3 looks at the institutional dards and practices also need to be addressed. Even- infrastructure--legal, regulatory, accounting, and tually these standards, regulations, and practices need auditing standards and practices--that is needed for to converge if countries are to be able to fully integrate good information disclosure and the effective exer- their financial markets and reap the resulting benefits. cise of corporate governance. These are the most Policymakers also need to be aware that, while important underpinnings to address for the devel- markets and instruments for transferring and shar- opment of the financial sector as a whole. The report ing risks offer tremendous potential for enhancing then looks at the key issues and policy challenges to the efficiency of financial markets and for better dis- be addressed in the banking sector (Chapter 4) and tributing risks among market players, inappropriate in the development of the securities markets (Chap- risk transfer also poses dangers. Strengthening the ter 5). Given the potential benefits of more diversi- FIGURE 7 Structure of the Report Regional-level initiatives to Domestic-level facilitate cross-border measures to develop flows and deepen markets financial intermediaries through integration and markets Key impediments Institutional infrastructure (chapter 3) to integration and ABF II bond fund to invest in local currency bonds: initiatives that are identifying regulatory bottlenecks in domestic markets Banking (chapter 4) being, and could to cross-listing; built-in incentives to reduce regulatory Origination of loans for securitization be, taken at barriers due to allocation of country weights in PAIF. the regional level Possibility of creating new indexes: deepening Securities markets (chapter 5) (chapter 2) domestic markets. Equities Bonds ABMI: regional infrastructure facilitating issuance at regional level and helping to deepen domestic markets NBFIs (chapter 6) Institutional investor demand for cross-border Institutional investor base investment opportunities Derivatives & Markets for securitization Development of derivatives can facilitate risk sharing (chapter 7) cross-border investment Growing linkages across market segments (chapter 8) Overview and Summary 23 fied financial systems, and the fact that countries in ulatory and supervisory challenges that may arise the region lag somewhat behind in the development from greater linkages across financial market seg- of their bond markets, Chapter 6 reviews means of ments, including through the use of derivatives and developing the investor base (pension funds, insur- securitization. ance, and mutual funds) in order to support deeper Figure 7 summarizes the structure of the report, securities markets. Chapter 7 discusses the develop- highlighting the potential synergies and two-way in- ment of instruments and mechanisms for sharing teractions between the measures that are being taken and transferring risk. Further growth in derivatives at the regional level to develop the bond markets and and securitization would advance the development the policy measures at the domestic level that can lead of securities markets as well as of the financial sys- to more developed and diversified financial markets tem overall. Chapter 8 concludes, discussing the reg- in the region. Moving Toward 1 a More Robust and Diversified Financial System Diversification allows a Since financial markets and intermediaries perform the key func- tions of financial systems in different ways and each may be bet- financial system to allocate ter at certain aspects, they tend to be complements, or imperfect assets and bear risks more substitutes (Box 1.1). Indeed, financial intermediaries and mar- efficiently. Since the 1997 kets are also complementary in that the former are key partici- pants in financial markets and tend to play a role in helping these financial crisis, policy- markets function well. A classic example of this is the mutual fund makers in East Asia have industry.25 focused on the need to At the same time, however, because financial intermediaries and markets are not perfect complements, and can substitute for each diversify the financial sec- other up to a point, a broadly based financial system may be more tor, encouraging the partic- stable and robust in times of economic downturns or crisis.26 Though the distinction among financial intermediaries and mar- ipation of different types kets has become blurred worldwide over the past five to ten years, of specialized intermedi- driven by deregulation, liberalization, and technological innova- aries and markets. Much tions, it is still the case that a diversified financial structure will gen- erally better serve the needs of the real sector. And, by offering a progress has been made in this respect, but the East Asian economies still lag in BOX 1.1 Importance of a Diversified Financial System the development of their Diversifying a financial system is beneficial because the participation bond markets relative to of different types of specialized intermediaries tends to be accompa- nied by the provision of a wider variety of services that cater to the the other segments of the needs of different agents. Another reason is that financial intermedi- aries and markets tend to perform the core functions of a financial financial system. system--resource mobilization, resource allocation, and manage- ment of financial risks--in different ways, and each may be better at certain aspects of these functions.a On the one hand, it has been argued that financial intermediaries are better able to screen potential investment opportunities because they can better mitigate the so-called free rider problem that is asso- ciated with the private production of information.b Because private loans are not traded, other institutions or market participants cannot freely ride on the intermediary that is monitoring and screening the project. As a result, financial intermediaries have greater incentives to acquire costly information. (Continued) 25 26 East Asian Finance BOX 1.1 Importance of a Diversified Financial System (Continued) Financial intermediaries may also be more effective at providing external finance to new firms that require staged finance, because intermediaries can more credibly commit to making additional funding available as a project devel- ops. Financial markets are less effective at providing pre-committed staged financing, because it is generally not pos- sible to get the owners of publicly traded securities to determine collectively whether additional funds should be provided. On the other hand, it has been argued, when financial intermediaries enter into a debt contract with firms, they have a natural bias toward low-risk projects with a high probability of success. The disadvantage is that these low-risk projects also tend to produce low returns. Financial markets may be more likely to fund higher-risk projects, since with equity financing they share in the upside. Indeed, it has been argued that specialized intermediaries and financial markets can deal more successfully with uncertainty and innovation. Financial intermediaries and markets also differ somewhat in their approaches to risk sharing. Standard risk diversifica- tion arguments concentrate mainly on cross-sectional risk sharing, which requires that individuals at a given point in time diversify their portfolio of assets. If there are fixed costs associated with each transaction of assets, financial intermediaries can take advantage of economies of scale to reduce the costs of holding a diversified portfolio of assets. Arguably, though, financial markets are an even better means to achieve cross-sectional risk sharing, because they allow individuals in the mar- ket to build the most suitable portfolio from a wide variety of assets. As regards inter-temporal risk smoothing--of risks such as commodity or other macroeconomic shocks that cannot be diversified at a given point in time--financial intermediaries have an advantage over markets. Inter-temporal risk smoothing requires investors to accept lower returns than those the market offers in good times, in order to get higher returns than those the market offers in bad times. Because it requires the accumulation of large reserves in relatively safe assets, it is better provided by financial intermediaries. Markets cannot do this, since investors in markets continually adjust their portfolios in search of the highest rate of return. a. There has been much debate as to whether financial intermediaries or financial markets are better for growth. This debate is based on the view that financial intermediaries and markets are strict substitutes. Overall, however, the evidence does not point to one or another being superior for growth. A third view suggests that financial intermediaries may provide complementary services to those of intermediaries and mar- kets, and emphasizes that what matters is to create an environment in which both intermediaries and markets can function better. Finally, the law and finance view, which is consistent with the financial services view, emphasizes the importance of the legal environment and the enforce- ment of contracts. b. The free-rider problem emerges when individuals who do not pay for information take advantage of the information that other individ- uals have paid for. A direct consequence of this problem is that it discourages the private market from producing enough information to elimi- nate the asymmetric information that leads to adverse selection and moral hazard. Source: Dolar and Meh 2002. wider array of risk-sharing mechanisms, it also the United Kingdom, or Germany, and in aggregate increases the risk-bearing capacity of the economy. still only account for 6 percent of world stock mar- Recognizing the importance of having more diver- ket capitalization. But in relation to the size of do- sified financial systems--particularly after the 1997 mestic economies they compare very favorably financial crisis--the region's policymakers have with those of advanced industrial countries. Indeed, focused much attention and effort over the past stock market capitalization as a percentage of gross few years on deepening and diversifying financial domestic product (GDP) is larger in Hong Kong markets. The past eight years have seen significant (China), Singapore, or Malaysia than in the United growth of assets in banking, equity, and bond mar- States, the United Kingdom, or Germany. kets (Table 1.1 and Figure 1.1). At US$9.6 trillion in The region's bond markets have also achieved assets, the East Asian financial markets in 2005 were sizable growth over the past six or seven years, albeit equivalent to about 21 percent of the U.S. financial with considerable variation across countries. In the market and almost half that of Japan. region as a whole, bonds outstanding amounted to Measured in terms of market capitalization, US$1.4 trillion in 2004 and US$1.5 trillion in 2005. East Asia's equity market has tripled since 1997-- Across the world, countries' financial structures amounting to US$2.3 trillion in 2004 and US$2.8 tril- vary widely, but given their per capita incomes and lion in 2005. Stock markets in the region are still the depth of their financial markets overall, East Asia considerably smaller than those in the United States, lags in the development of the bond markets relative Moving Toward a More Robust and Diversified Financial System 27 TABLE 1.1 Structure of Financial Systems (percent of GDP) Bank assets Equity market capitalization Bonds outstanding Economy 1997 2004 2005 1997 2004 2005 1997 2004 2005 China 124.6 176.4 163.1 11.2 23.1 17.8 12.9 24.9 24.4 Indonesia 31.1 14.6 49.8 12.2 28.8 28.9 1.9 22.6 19.6 Rep. of Korea 37.9 130.1 93.5 8.1 57.1 91.2 25.2 83.3 76.2 Malaysia 100.9 169.09 159.4 93.2 153.3 138.0 57.0 90.0 88.0 Philippines 56.1 66.5 63.2 37.7 33.0 40.4 22.4 28.4 36.7 Thailand 79.7 129.2 103.6 15.1 71.4 70.1 7.1 40.7 40.8 Hong Kong 205.1 337.5 444.6 234.5 519.5 593.6 26.0 47.1 46.6 (China) Singapore 122.0 176.8 185.4 110.8 202.3 220.4 24.7 73.1 68.2 Source: International Monetary Fund International Financial Statistics; (IMF IFS) Bank for International Settlements (BIS), Asian Development Bank (ADB) Asian Bonds Online, and World Bank staff calculations. to the other financial segments (Figure 1.2).27 Much total financial assets at the end of 2005 (down from of the growth in bond markets (more than 50 per- 63 percent in 1997). cent of the growth during 1997­2004 in all econo- The assets of institutional investors--pensions, in- mies in the region except Hong Kong (China) and surance, and mutual funds--have also grown over the Korea) has been on account of bonds issued by gov- past few years, and now amount to US$1.5 trillion or ernments, largely to restructure banking systems. around 45 percent of GDP in the region as a whole. Although corporate bonds have provided a reason- The institutional investor base is much smaller in able share of the growth in several countries, in most some countries than in others, however, and is still a countries they remain a small proportion of the very small percentage of GDP in China, Indonesia, overall bond market.28 and the Philippines (Figure 1.3). While the size of in- Despite the progress made in diversifying finan- stitutional investors typically grows along with a cial markets, the banking sector remains dominant, country's per capita income, this is another area that accounting for around 58 percent of the region's countries in the region need to develop further. FIGURE 1.1 Assets of the Financial Sector (percent of GDP) a. Financial sector assets, 1997 b. Financial sector assets, 2004 1,200 1,000 bonds bonds 1,000 equities 800 equities banks banks 800 GDP 600 of 600 400 percent 400 200 200 0 0 ina sia rea sia s nd e s e s ilippine, ChinahailaSing ain key ina rea sia es ain key Ch Ko lay lay xico Sp r Tu Indone. of Ma T apord StateMexico Sp r Tu Ch onesiaKo Ma , Chinahailandapord StateMe T p Ph ite Ind . of p Philippin Sing te i Re Kong Un Re Kong Un Hong Hong Source: Asian Bonds Online, BIS, IFS and WFE, WDI and World Bank Financial Structure Database. 28 East Asian Finance FIGURE 1.2 Importance of Bank Assets Relative to Equity and Bond Markets a. Bank assets to stock market capitalization b. Bank assets to bonds outstanding 8 China Hong Kong, China China 6 4 ratio ratio Thailand Philippines Singapore Philippines Rep. of Korea 2 Malaysia Thailand Rep. of Korea Malaysia Singapore Indonesia Hong Kong, China Indonesia 0 0 10 20 30 40 0 10 20 30 40 per capita GDP per capita GDP Source: Asian Bonds Online, BIS, IFS and WFE, WDI and World Bank Financial Structure Database. FIGURE 1.3 Assets of Institutional Investors (percent of GDP) a. Assets of institutional investors, 2004 b. Assets of institutional investors 350 350 mutual funds Hong Kong, China 300 insurance 300 P pension funds DG 250 250 of P 200 DGfo 200 %stessal 150 % 150 Singapore Malaysia 100 100 ionatutits Rep. of Korea in 50 Philippines 50 China 0 Indonesia 0 ina sia nes 0 10 20 30 40 50 Ch ailand , China apore per capita GDP, US$ billions Indone Th Rep.of Korea Malaysiahilippi P Kong Sing Hong Source: HSBC, Dalla 2005, BNM, BOT, OECD. Regional Cooperation 2 as a Means to Diversify Financial Markets Financial integration provides investors with a broader range of in- vestment opportunities while providing firms with a broader base of investors to tap for funding. Integration can enhance market liquid- ity, which may be very limited in segregated markets. And it can exert competitive pressures on markets and intermediaries, thus reducing transaction costs and increasing the incentives for innovation. Regional cooperation can By providing an impetus to financial integration and poten- be a powerful means to tially generating a wider set of dynamics, regional initiatives can help in further developing and diversifying the financial markets deepen and diversify finan- in the region. The potential gains to be reaped from greater inte- cial markets through inte- gration range across the financial segments--banking, equity, and bond markets. However, it is the bond markets that are at present gration, but it needs to be the least financially integrated, and in general, bond markets can complemented by actions benefit from scale economies. and measures at the Over the past few years, East Asian policymakers have under- taken several major initiatives to foster regional financial integra- domestic level. tion, particularly in the bond market, as a means to deepen and diversify financial markets. In this context, this chapter looks at the following set of questions: How financially integrated are countries in the region, both globally and among themselves? What is the scope for reaping benefits through further integration? How can the regional initiatives stimulate greater integration? What are the remaining key impediments to cross-border flows and greater integration, particularly with regard to bond markets, that countries could address in a coordinated manner at the regional level? How can the synergies between regional initiatives and domestic policy measures be maximized to deepen and diversify markets? Extent of Financial Integration East Asian economies are much more integrated with the rest of the world through capital inflows than through capital outflows. The region has traditionally received large inflows of capital from global markets, and now that flows have resumed since the 1997 crisis, it is once again the region with the largest inflows of capital. Flows of outward investment from economies in the region-- whether to other economies in the region or globally--are increasing but still relatively small (Table 2.1). Bank claims abroad 29 30 East Asian Finance TABLE 2.1 Holdings of Foreign Assets and Liabilities with the Rest of the World (percent of GDP) Foreign direct Other investments investment Portfolio equity Portfolio debt Economy Liabilities Assets Liabilities Assets Liabilities Assets Liabilities Assets China n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Indonesia 51.2 5.5 6.2 0.0 6.1 0.0 4.0 1.1 Rep. of Korea 17.1 9.9 12.9 4.7 22.9 1.3 8.3 2.3 Malaysia 47.4 24.1 36.8 10.8 23.6 0.8 8.9 1.04 Philippines 46.2 12.1 15.0 2.2 3.6 0.2 19.6 5.3 Thailand 25.0 10.7 32.7 2.3 16.5 0.4 3.4 0.6 Hong Kong 194.2 257.1 273.2 243.1 86.5 120.4 7.2 121.3 (China) Singapore 184.2 199.8 164.6 103.7 55.1 46.4 17.7 49.0 Source: IMF IFS. Notes: "Other investments" assets and liabilities comprise all financial transactions not covered under direct investment, portfolio (equity and debt) investment, financial derivatives, or reserve assets. Major items in the "other investments" category are transactions in currency and deposits, loans, and trade credits. are equivalent to 10­12 percent of GDP, on average, in China, Malaysia, the Philippines, and to a lesser ex- for economies in the region, except for Malaysia tent, the Republic of Korea, countering the overall (around 25 percent of GDP) and Hong Kong (China) trend. Elsewhere in the region (Indonesia, Singapore, and Singapore. Portfolio holdings held abroad are and Thailand), the pattern is complex: while claims much smaller, averaging 4­5 percent of countries' from banks outside the region have declined, those GDP for portfolio debt assets, and less than 1 percent from banks within the region ("other") have in- of GDP for portfolio equity assets. creased, in some cases quite significantly (Table 2.2). Recent transactions point to an increasing interest in regional cross-border acquisitions, suggesting that Bank claims interconnected banking markets could become an Cross-border bank claims outstanding on coun- important channel for regional integration. During tries in the region have declined in aggregate since 2000­05, banks in Hong Kong (China) and Singa- the financial crisis (from US$691 billion in 1995 to pore made several investments in banks within the re- US$477 billion at end-2004), but they have increased gion (Appendix Table 2.1). TABLE 2.2 Consolidated Bank Claims (US$ billions) European USA Japan Union Other Total Economy 1995 2004 1995 2004 1995 2004 1995 2004 1995 2004 China 1.7 5.7 17.6 14.0 16.1 26.8 12.9 34.0 48.3 80.6 Indonesia 2.7 1.5 20.9 4.8 11.2 8.9 6.5 14.9 44.5 30.6 Rep. of Korea 7.5 6.7 21.4 13.6 16.3 23.4 32.1 37.5 77.5 81.3 Malaysia 1.5 1.8 7.3 4.4 3.9 10.6 3.9 16.3 16.7 33.2 Philippines 2.9 1.6 0.9 2.4 2.8 5.5 1.5 10.2 8.3 19.8 Thailand 4.1 1.4 36.8 4.9 10.1 4.6 11.7 8.4 62.8 19.4 Hong Kong 7.2 6.9 133.0 19.0 56.3 40.0 43.9 42.0 240.0 108.0 (China) Singapore 6.1 3.2 76.9 14.3 60.0 33.3 49.3 52.2 192.0 103.0 East Asia region 34.0 29.0 315 77.0 177.0 154.0 165.0 216.0 691.0 477.0 Source: BIS Consolidated Banking Statistics. Note: The table shows the outstanding claims of foreign banks on countries in the region, broken down by these banks' countries of origin. The "other" category, for which no breakdown is available, includes East Asian banks. Regional Cooperation as a Means to Diversify Financial Markets 31 Portfolio investments ments into developing East Asian countries, in both equity and bonds (to US$38 billion and US$29 bil- The East Asian countries have become more finan- lion respectively). cially integrated in portfolio investments both with Developing East Asian countries' holdings of equi- global markets and among themselves over the past ties have increased in the United States, Japan, and the few years. East Asian new industrial economies, as well as within Integration through portfolio investments has ex- other developing East Asian countries. Developing panded (Table 2.3). Since 1997, the region has seen a large rise in inward portfolio-equity investments East Asian countries' bond investments have re- (from US$131 billion to US$474 billion) and bond mained much more concentrated; they have mainly investments (from US$81 billion to US$149 billion). been directed toward the United States, Japan, and the The region's outward investments have also grown European Union, and only to a much lesser extent to over this period: those in equity have risen from the East Asian NIEs. And, within developing East Asia, US$19 billion to US$267 billion, and those in bonds cross-border holdings of bonds remain very small, at from US$20 billion to US$352 billion. around US$0.1 billion at end-2004. Much of the activity reflects investments to and In equity markets the increased integration, both from the new industrial economies (NIEs) of Hong globally and within East Asia, is corroborated in the Kong (China), Korea, and Singapore. The NIEs have increased correlations of equity returns across coun- substantially increased their bond and equity hold- tries (Table 2.4). ings both outside and within East Asia. Their invest- Two separate pieces of econometric analysis also ments in one another's economies, and particularly corroborate this increase in integration (Box 2.1). in bonds, have grown rapidly (from US$1 billion in The fact that, despite the recent trends of greater 1997 to US$23 billion in 2004), as have their invest- integration, the correlations in equity returns are still TABLE 2.3 Portfolio Investment Assets and Liabilities (US$ billions) East Asian new United European industrial Developing States Japan Union economiesa East Asiab Others Total Region 1997 2004 1997 2004 1997 2004 1997 2004 1997 2004 1997 2004 1997 2004 Equity As recipients: East Asia 61.7 192.0 7.6 17.4 43.7 174.0 8.8 54.9 0.8 0.9 14.7 50.4 131.0 474.0 NIEs 47.3 160.0 5.5 12.5 35.5 138.0 2.7 16.9 0.7 0.8 12.7 40.6 98.3 352.0 Dev EA 14.4 32.4 2.0 4.9 8.1 36.7 6.0 37.9 0.1 0.2 1.9 9.7 32.6 122.0 As investors: East Asia 2.0 25.9 0.2 9.1 4.8 69.1 3.5 17.7 6.1 38.1 2.0 107.4 18.8 267.0 NIEs 1.9 25.6 0.2 9.0 4.4 68.9 2.7 16.9 6.0 37.9 1.7 107.4 17.1 265.0 Dev EA 0.1 0.3 0.0 0.1 0.4 0.2 0.7 0.8 0.1 0.1 0.3 0.4 1.6 1.9 Bonds As recipients: East Asia 33.3 25.1 21.6 11.2 18.9 46.0 5.0 51.6 0.4 0.5 2.5 20.4 81.0 149.0 NIEs 16.1 14.5 11.5 7.5 11.1 26.9 1.0 22.7 0.3 0.3 1.7 15.4 40.7 81.4 Dev EA 17.2 10.8 10.0 3.7 7.9 19.2 4.1 29.0 0.2 0.1 0.8 5.0 40.2 67.0 As investors: East Asia 5.0 82.1 1.0 9.5 2.1 119.0 1.2 23.1 4.3 29.1 7.0 87.4 20.1 352.0 NIEs 4.8 78.5 1.0 9.4 2.0 117.0 1.0 22.7 4.1 29.0 6.2 85.8 19.1 343.0 Dev EA 0.2 3.7 0.0 0.0 0.2 3.1 0.3 0.4 0.2 0.1 0.8 1.4 1.56 8.8 Source: IMF, Coordinated Investment Portfolio Survey. Notes: The table shows holdings in equities and bonds, with the East Asia region both as a recipient of investments from other markets (United States, Japan, European Union, the East Asian new industrial economies, "developing East Asia," and "others"), and as investor in these markets. a. New industrial economies (NIEs) are Hong Kong (China), Korea, and Singapore. b. Developing East Asia (Dev EA) is China, Indonesia, Malaysia, the Philippines, and Thailand. 32 East Asian Finance TABLE 2.4 Correlation in Equity Returns Hong Kong Economy Indonesia Korea Malaysia Philippines Thailand (China) Singapore Japan East Asia United States European Union G-7 Indonesia 1.00 0.09 0.09 0.30 0.23 0.31 0.29 0.08 0.36 0.11 0.18 0.15 1.00 0.25 0.25 0.40 0.40 0.25 0.38 0.23 0.33 0.07 0.14 0.09 Rep. of Korea 1.00 0.23 0.06 0.14 0.18 0.29 0.20 0.27 0.15 0.41 0.16 1.00 0.22 0.43 0.49 0.62 0.59 0.47 0.70 0.36 0.43 0.30 Malaysia 1.00 0.34 0.49 0.53 0.69 0.26 0.57 0.29 0.36 0.09 1.00 0.19 0.38 0.28 0.34 0.26 0.37 0.18 0.11 0.15 Philippines 1.00 0.35 0.32 0.31 0.03 0.40 0.12 0.21 0.00 1.00 0.49 0.36 0.42 0.28 0.48 0.21 0.23 0.16 Thailand 1.00 0.46 0.49 0.16 0.46 0.19 0.29 -0.01 1.00 0.50 0.59 0.37 0.60 0.26 0.24 0.20 Hong Kong, China 1.00 0.53 0.17 0.51 0.31 0.37 0.07 1.00 0.70 0.51 0.69 0.47 0.55 0.31 Singapore 1.00 0.37 0.62 0.36 0.48 0.09 1.00 0.48 0.74 0.38 0.49 0.29 Japan 1.00 1.00 East Asia 1.00 1.00 United States 1.00 1.00 European Union 1.00 1.00 G-7 1.00 1.00 Source: Datastream, dividend-adjusted return indexes; except for G-7: Morgan Stanley Capital International (MSCI) return index. Notes: First number in cell is before crisis (1990­July 1997); second number is after crisis (July 1999­June 2005). Malaysia's lower correlations likely reflect not only the increased integration but also the imposition of capital controls dur- ing and in the aftermath of the crisis. Regional Cooperation as a Means to Diversify Financial Markets 33 BOX 2.1 Tests of Integration in Equity Markets Analysis of equity returns suggests that the region is becoming more integrated in equity markets. Here we test the degree of integration of individual equity markets with markets in the rest of the region and with global markets by observing the underlying drivers of co-movements in equity returns. This "news-based" approach investigates integration indirectly by looking at how domestic return innovation is affected by regional or global news.a Central to this approach is the assumption that domestic returns can be decomposed into two components: the ex- pected component and the unexpected component (or news). Conditional upon the expected component, shocks or news from regional or global markets will affect the return on domestic equity. Thus, as domestic markets become more integrated, the importance of regional or global news in explaining domestic returns is likely to increase. The empirical equation for testing the effects of regional and global effects is given by the following GARCH (1,1): Rit = 0 + 1Zit -1+ 2Rt -1+ 3Gt -1+ Let + Get + it R G (1) where Ri is the equity return of country i, Zi is a set of instruments consisting of lagged local dividend yields, and lagged returns, Gt -1 and Rt -1are global and regional excess return, as described in Bekaert and others (2005), eGt and eRt are global and regional shocks, and it N(0, ,it), with conditional variance of: 2 2,it = 0 + 1it 2 -1+ 22,it -1+ it2 -1 (2) To test for parameter shifts before and after the Asian economic crisis, after the crisis is defined as prior + I after, where I is the after-crisis indicator variable which takes the value 1 after July 13 1999. The significance of the shift in is tested using the Wald test. The results of the first integration test are given by the s of Equation 1, which directly measure the volatility spillover, i.e., the intensity of regional and global news to domestic equity returns. As shown in the table below, they suggest that regional integration has increased significantly. Estimates for Volatility Spillover Coefficients Hong Kong News Indonesia Malaysia Philippines Singapore Thailand (China) Korea Regional before the 0.474 0.467 0.616 0.324 0.641 0.419 0.253 crisis (0.065) (0.045) (0.114) (0.024) (0.071) (0.042) (0.051) after the 0.905 0.385 0.592 0.689 0.921 0.599 1.309 crisis (0.130) (0.064) (0.079) (0.052) (0.095) (0.041) (0.083) Wald test: no shift after the crisis (P-value) 0.003 0.293 0.862 0.000 0.019 0.002 0.000 US (global) before the 0.286 0.625 0.391 0.624 0.389 0.705 0.173 crisis (0.088) (0.079) (0.106) (0.123) (0.084) (0.140) (0.081) after the 0.073 0.109 0.226 0.280 0.341 0.486 0.616 crisis (0.205) (0.074) (0.057) (0.044) (0.070) (0.041) (0.070) Wald test: no shift after the crisis (P-value) 0.338 0.000 0.171 0.008 0.662 0.132 0.000 Wald test: after the crisis R = G (P-value) 0.005 0.008 0.001 0.000 0.000 0.045 0.000 The second test is the variance ratio used by Ng (2000) and by Beale and others (2004). This ratio captures the pro- portion of volatility in domestic equity returns that is explained by regional or global news. The ratio is obtained by first computing the variance of the innovation component of domestic returns from equation 1: 2it = Ret ( R)2 + Get ( G)2+ 2,it (3) (Continued) 34 East Asian Finance BOX 2.1 Tests of Integration in Equity Markets (Continued) The global and regional variance ratios are then the proportion of the variance of domestic return innovations that is explained by global or regional news: VRit = ( G et )2 ( R et )2 G G 2it and VRit = R R respectively. 2it As the following figure shows, these results are consistent with those of the first test. Most countries in the East Asia region (except Malaysia, whose results reflect the capital controls that the government imposed in the aftermath of the crisis) have become more integrated. In large part, this reflects greater integration within the region. Proportion of domestic stock return variance explained by regional or global shocks 60 global 50 regional 40 tne rcep 30 20 10 0 before after before after before after before after before after before after before after crisis crisis crisis crisis crisis crisis crisis crisis crisis crisis crisis crisis crisis crisis Indonesia Rep. of Malaysia Philippines Thailand Hong Kong, Singapore Korea China a. Regional and global shocks are calculated by fitting a univariate GARCH (1,1). For the regional model, regressors include instruments con- sisting of the regional average dividend yield, past returns, and past global excess returns. For the global (U.S.) model, the regressors are: in- struments consisting of lagged changes in the 3-month Treasury bill yield, the lagged spread between the yields of a 3-month Treasury bill and a 10-year Treasury bond, and the lagged spread between the 3-month Treasury bill rate and the 3-month Eurodollar rate. China is not included in the analysis. Source: Rahardja 2006. quite low signifies that the East Asian economies still Enhancing Integration through have scope to benefit from further financial integra- Regional Initiatives tion. Except in Hong Kong (China) and Singapore, Most of East Asia's regional integration efforts in the the correlations are below 0.6 in most cases, and the financial arena have focused on developing a regional coefficients (betas) on global and regional shocks, as bond market. The following discussion reviews the well as the proportion of domestic-equity-return in- measures taken in the bond markets and then high- novations that can be explained by either global or re- lights factors that still impede cross-border integra- gional shocks in the variance-ratio analysis, are also tion, suggesting some areas for further inter-regional still relatively low. cooperation. The potential gains from diversifying through the bond markets appear higher still. Holdings of bonds Bond market measures within the region are still very small and, as Table 2.5 shows, the correlations among bond returns are in With their small size and fragmentation across na- most cases below 0.25. tional boundaries, bond markets in much of East Asia TABLE 2.5 Correlation in Local-Currency Bond Returns Rep. United of Hong Kong King- United China Indonesia Korea Malaysia Philippines Thailand (China) Singapore Japan Germany dom States China 1.00 0.22 0.17 0.13 0.03 0.05 0.02 0.05 0.09 0.00 0.04 -0.03 Indonesia 1.00 0.19 -0.01 -0.09 0.06 -0.12 0.01 0.08 -0.03 -0.04 -0.08 Rep. of 1.00 0.26 -0.03 0.16 0.53 0.49 0.13 0.46 0.37 0.50 Korea Malaysia 1.00 -0.05 0.23 0.39 0.50 0.26 0.35 0.27 0.33 Philippines 1.00 0.15 0.04 -0.06 0.14 -0.04 -0.05 0.05 Thailand 1.00 0.27 0.15 0.04 0.34 0.35 0.24 Regional Hong Kong 1.00 0.67 0.25 0.73 0.64 0.83 (China) Singapore 1.00 0.36 0.61 0.54 0.66 Cooperation Japan 1.00 0.27 0.24 0.25 Germany 1.00 0.92 0.87 United 1.00 0.78 Kingdom as United 1.00 a Means States Source: HSBC 2004. to Diversify Financial Markets 35 36 East Asian Finance have not been able to benefit fully from the economies have been launched using a portion of EMEAP's inter- of scale that are generally associated with successful national reserves (Box 2.2). bond-market development. Some of the regional in- The first of these funds, the Asian Bond Fund 1 tegration measures that governments have taken ad- (ABF1), pooled US$1 billion of reserves and invested dress what may be termed demand-side constraints in U.S. dollar-denominated government and quasi- (from the perspective of investors) while others ad- government bonds of eight ASEAN+3 countries. The dress the supply side (from the perspective of issuers). second (ABF2), of US$2 billion, actually consisted of nine separate funds: a Pan Asian Bond Index Fund "Demand-side" measures (PAIF) and eight single-country funds. ABF2 is in- Under the Executives' Meetings of East Asia­Pacific vesting in local currency denominated sovereign and Central Banks (EMEAP)29, two Asian Bond Funds quasi-sovereign bonds. Its aim is to give both retail BOX 2.2 The Asian Bond Fund Initiative The first Asian Bond Fund (ABF1) was launched in June 2003, and the second, ABF2, was launched in April 2005. ABF1 pooled US$1 billion of reserves of the eleven EMEAP economies to invest in U.S. dollar­denominated government and quasi-government bonds. ABF2, of US$2 billion, has invested in local-currency-denominated government and quasi- government bonds and consists of nine funds: the Pan Asian Bond Index Fund (PAIF) and eight single-country funds. These funds are being managed by private-sector fund managers, who have been given the mandate to manage them passively to replicate bond indexes provided by the International Index Company. Thus each of the eight single-country funds replicates a local currency bond market index, while PAIF replicates the iBoxx Pan Asia index. PAIF is the first low- cost, passively managed investment fund invested in the eight EMEAP local bond markets and the first foreign fund to have direct access to China's interbank bond market. PAIF was listed on the Hong Kong (China) Stock Exchange in August 2005, and listings on other stock exchanges will be considered, depending on demand from local investors and on local regulations. During phase one, ABF2 was limited to the reserves of the central banks. Since then, the fund has been enlarged through private placements by institutional investors, participating dealers, and market makers. Other investors will be able to acquire units on the secondary market. The strategy has been designed to keep costs low and avoid the volatility that is usually associated with a sale-driven initial public offering. Investors can trade units in the fund in two ways: they can go to its trustees through dealers to buy or redeem units at the day's closing net asset value, thus engaging in a transaction in the primary market, or, because PAIF is an exchange- traded fund, they can trade throughout the day on the stock exchange, thereby operating in the secondary market (see figure below). INVESTORS buying and selling buying and selling Participating Stock exchange dealers subscription liquidity and redemption arbitrage PAIF trustee Market makers primary market secondary market Regional Cooperation as a Means to Diversify Financial Markets 37 BOX 2.2 The Asian Bond Fund Initiative (Continued) To concentrate liquidity in the secondary market, there will be some restrictions on trading PAIF units in the primary market. Nonetheless, the primary market will continue to provide an important means of arbitrage to ensure that the secondary market prices stay in line with the fund's net asset value. In the primary market, PAIF will follow the partici- pating dealer model, which limits the daily subscriptions and redemptions to dealers who have signed an agreement with the fund manager. To help the manager deal with cash inflows and outflows, there will be a limit on the total daily vol- umes and the manager will charge a dilution fee. However, there will be no such limit or dilution fee for transactions that involve the exchange of a basket of bonds (i.e. in-kind subscriptions or redemptions for shares). Engaging in such trans- actions will be at the discretion of the fund manager. In the secondary market, the fund manager will appoint market makers to provide liquidity in the trading of units on the stock exchange. The market makers will be expected to main- tain tight bid and offer quotes on the exchange, and to seize opportunities for arbitrage by closely monitoring the fund's net asset value and comparing it with the prices on the exchange. Because it is an exchange-traded fund (ETF), PAIF should appeal to a broad range of investors. Exchange-traded funds (ETFs)--which are index funds representing a basket of stocks that trade on the exchange--have several advantages. First, they offer the diversification benefits of mutual funds but are traded like stocks. Thus, unlike mutual funds that are priced once a day at the close of business, ETFs can be traded intra-day, thereby offering investors the opportunity to bet on the di- rection of shorter-term market movements through the trading of a single security. Also, unlike mutual funds, ETFs can be used for speculative trading strategies such as short selling and trading on margins. In short, an ETF allows an investor to trade the entire market (covered by the index the ETF mirrors) as though it were a single stock. Second, there are no minimum pur- chase sizes: investors can purchase as few shares of an ETF as they want--a feature that may appeal to smaller retail investors. Finally, the unique structure of an ETF enables those investors (generally institutional investors) who are trading large vol- umes to obtain in-kind redemptions, i.e. to redeem them for shares of the stock that the ETF tracks. This arrangement mini- mizes the tax implications for an investor exchanging the ETF, since the investor can defer most taxes until the investment is sold. Source: Ma and Remolona 2005. and institutional investors access to local bond mar- "Supply-side" measures kets in the region in a transparent and cost-effective Working groups under ASEAN+3 and APEC have manner. In particular, by reaping economies of scale addressed some of the supply-side constraints on that can be obtained by passively tracking an index, cross-border investments, including the issuance of costs can be kept relatively low and transparent. new securitized debt instruments; credit guarantee The Pan Asian Bond Index Fund (PAIF) is de- and enhancement mechanisms; foreign-exchange signed to be open-ended as well as exchange-listed. Its transaction and settlement issues; the issuance of design, whereby the primary market can provide an bonds denominated in local currency by multilateral important means of arbitrage to ensure that the sec- development banks, foreign agencies, and multilat- ondary market prices stay in line with the fund's net eral corporations; and local and regional credit-rating asset value, should also enhance efficiency. And by agencies. offering the advantages of an exchange-traded fund, PAIF should appeal to a broader range of investors. Addressing remaining impediments ABF2 should also provide an impetus to broader to cross-border investments market development in two ways. First, like ABF1, by being an actual fund it has allowed policymakers What are some of the remaining impediments to to learn from experience and has helped to identify greater cross-border investments and integration of critical impediments to cross-border listing and in- financial markets within the region that countries vesting. Second, it is expected to spur the intro- could consider addressing at the regional level? duction of new instruments for investors: since the Regulations prohibiting or restricting capital in- construction of the index and the compilation meth- flows and outflows have been progressively reduced, odology will be published, managers of private funds and, except in China, they are now fairly minimal can use these indexes as benchmark indexes and (Table 2.6). replicate or customize them for their fixed-income But several other factors still impede cross- products. border transactions. They include taxation, a lack of 38 East Asian Finance TABLE 2.6 Regulations Affecting Cross-Border Flows Financial Hong Kong segment China Indonesia Korea Malaysia Philippines Thailand (China) Singapore Credit markets Foreigners can borrow locally Y N L Y Y N Y Y Residents can borrow abroad L Y Y L Y Y Y Y Equity markets Foreigners can buy locally L Y Y Y Y L Y Y issue locally Y Y Y A Y A Y Y Residents can buy abroad N Y Y L Y Y Y Y issue abroad A Y Y Y Y A Y Y Bond markets Foreigners can buy locally N A Y Y Y Y Y Y issue locally N N Y A Y A Y Y Residents can buy abroad A Y Y L L A Y Y issue abroad A Y Y A Y Y Y Y Access to spot foreign exchange Foreigners can L Y to A to A to A to A to NR Y to purchase purchase purchase purchase purchase purchase bond bond bond bond bond bond Source: IMF. Notes: Y = yes; N = no; L = with restrictions or limits; A = approval required; NR = no restrictions. Bond market in China: qualified foreign institutional investors only, and only if the bonds are listed on one of the mainland's stock exchanges. hedging instruments, and differences in market prac- and multi-yield environments. To help investors ad- tices and infrastructure (trading platforms and con- dress foreign exchange risk, all countries of the region ventions, procedures for clearance, and settlement have either an onshore forward foreign exchange and custodian systems). At a deeper level, differences market or an offshore non-deliverable forward mar- in rating standards, national legal and regulatory ket (Table 2.8). All except China and Korea make frameworks, and accounting and auditing practices available local-currency funding for investment in add to costs and uncertainty for both issuers and debt securities to offshore investors providing proper investors. documentation.30 But the costs of hedging foreign- Taxes can strongly deter foreign investors from exchange risk are high, and hedging interest-rate risk participating in local markets. Recognizing this, over is somewhat more difficult, due to restrictions on the past few years a number of countries have unilat- foreigners' access to onshore interest-derivatives mar- erally, or under tax treaties, abolished their with- kets and the unequal development of onshore deriva- holding taxes on nonresidents in order to encourage tives markets. foreign participation in their bond markets. Several Differences in standards and procedures are also countries in the region have relatively high capital- a strong impediment. As discussed in Chapter 3, sig- gains taxes and/or interest-income taxes (Table 2.7). nificant differences still exist in some of the institu- The issue is now being studied by the ASEAN+3 tional underpinnings of financial markets--notably Working Group 1. different countries' legal and regulatory frame- High costs of hedging foreign exchange risks and works, disclosure requirements, and accounting and interest rate risks can also have important discourag- auditing standards and practices--which will take ing effects on trading, especially in multi-currency time to harmonize across national boundaries. Regional Cooperation as a Means to Diversify Financial Markets 39 TABLE 2.7 Tax Treatment of Returns from Foreign Investors' Holdings of Local Bonds Economy Tax liabilities China CGT: 5%. WHT on interest income: 10% for qualified foreign institutional investors. Indonesia CGT: 20%. WHT on interest income: 20%. Other tax: 0.1% of gross sale proceeds is withheld by the broker as income tax for securities transactions executed on the exchange. Rep. of Korea CGT: The lower of 11% of gross sales proceeds or 27.5% of net capital gains. WHT on interest income: 27.5%. Malaysia CGT: None. WHT on interest income: None. Philippines CGT: None for transactions on the exchange. WHT on interest income: 20%. Thailand CGT: 15%. No CGT on government bonds or certain quasi-government bonds. WHT on interest income: None for government or government-guaranteed debt; 15% otherwise. Hong Kong CGT: None. WHT on interest income: None. (China) Singapore CGT: None. WHT on interest income: None for government and certain quasi-government bonds. Source: Takeuchi 2005. Notes: CGT = capital-gains tax. WHT = withholding tax. Other differences exist in market infrastructure and nies do not get rated.32 Second, national rating agen- procedures. For example, Asian dollar bonds are cies' standards differ widely, making it difficult for cleared through the Euroclear and Clearstream foreign investors to assess investment possibilities. International clearing houses, with virtually no Third, no finely graded ratings within the region are settlement and counterparty risk. Local currency available to potential investors; at present there are Asian bonds are cleared through countries' own only international and national rating scales. clearing houses, which are typically located in, but A regional credit-rating agency? independent from, central banks and are often owned by the local exchange. To limit settlement Policymakers in the region may therefore wish to risk, most countries work on the basis of real-time consider the pros and cons of establishing a regional gross settlement and delivery versus payment sys- credit-rating agency. Such an agency could ensure tems.31 As regards procedures for settling foreign that an assigned rating would denote the same prob- exchange trades, at present countries differ in the ability of default in any East Asian country; it could extent of documentation needed and the length of provide more finely graded credit ratings than are the settlement procedures. now available on a regional scale; and it could help In fact, although clearance and settlements systems smaller companies to acquire ratings for their inter- are generally efficient, and current arrangements may national issuances (to the extent that there is cross- not be a strong impediment, harmonization of mar- subsidization). It could also help develop capabilities ket practices could facilitate cross-border investing for assessing credit risk and provide the necessary and reduce its cost. Korea has recently made a pro- training for the national rating agencies to speed the posal to look into developing Asian bond standards convergence of standards across the region. and procedures for the issuance of regional bonds. The merit of setting up a regional credit-rating This may also encourage a convergence of national agency would hinge critically on (1) the growth of standards and practices in the region. cross-border issuance and investments over the next five to ten years, and (2) the credibility that such an agency could establish for itself. This, in turn, would Possible new areas of regional cooperation depend on the governance structure that is estab- A key building block of a bond market is the assess- lished. In particular, the shareholder structure would ment of credit risk. From the perspective of cross- need to follow certain key principles: shareholders border investments, however, there are several issues. would need to be seen as credible and fostering in- First, although the three big international rating agen- dependence of operations; shareholding would need cies operate in the region, they rate only a small num- to be widely dispersed (and fortified by a strong share- ber of Asian firms and financial institutions that issue holders' agreement); the maximum shareholding in international markets; hence the smaller compa- would need to be limited to say 5­10 percent, unless 40 East Asian Finance TABLE 2.8 Availability and Access to Derivatives Markets for Cross-Border Investors Hong Kong Type of derivative China (China) Indonesia Korea Malaysia Philippines Singapore Thailand On-shore foreign- Up to Liquid Liquid Liquid Up to Liquid Liquid Liquid exchange forward 12 months 12 months Non-resident access Prior approval No restriction Allowed to hedge Allowed to hedge Allowed to hedge Prior approval Allowed to hedge Allowed to hedge to onshore forwarda required principal and principal and principal and required principal and principal and coupon coupon coupon coupon coupon Offshore foreign- NDF liquid None NDF liquid NDF liquid None NDF illiquid Deliverable Deliverable exchange market forward illiquid forward illiquid Interest-rate swap market No Liquid Illiquid Liquid Illiquid Very illiquid Liquid Liquid Non-resident access to No market No restriction Only receive IDR Allowed to hedge Allowed to Prior approval Allowed to hedge Allowed to hedge interest-rate swap rates bond-related hedge bond- required bond-related bond-related market a risk related risk risk risk Cross-currency swap No Liquid Illiquid Liquid Illiquid Very illiquid Yes Yes market Non-resident cross- No market No restriction Only receive IDR Allowed to hedge Allowed to Prior approval Allowed to hedge Allowed to hedge currency swap marketa rates bond-related hedge bond- required bond-related bond-related risk related risk risk risk Bond futures No Illiquid No Liquid Illiquid No Liquid No Exchange-traded No Liquid No Liquid Illiquid No Liquid No derivatives Sources: Barclays Capital, IMF, Takeuchi 2005, and country sources. NDF = non-deliverable forward; IDR = Indonesian Rupiah. a. To settle and/or hedge a purchase of local-currency bonds. Regional Cooperation as a Means to Diversify Financial Markets 41 the shareholder were an independent third party government involvement, governments would di- such as a rating agency or multilateral agency; and a vest their shares after a period of time (Box 2.3). balanced regional representation in the shareholding structure would be essential. Regional information sharing? Also, to ensure market performance, it would be With the growing potential for cross-border banking crucial to have a sunset clause whereby, if there is and other credit flows within the region, there may BOX 2.3 Rationale and Feasibility of Setting Up a Regional Credit-Rating Agency Although domestic and international credit-rating agencies have achieved a high penetration in East Asia, they use only local and international scales. Thus investors do not have a rating scale that allows a fine differentiation between credits on an intraregional basis. Moreover, smaller corporations in the region that wish to issue cross-border are not well served by existing rating agencies. Though cross-border issuance and investments in East Asia are still relatively limited, the next five to ten years are likely to see much more demand by investors within the region for regional investment opportunities, and more cross- border issuance (including structured finance products). The region already has high levels of savings and investible funds with high net worth individuals, and the assets of institutional investors are also likely to increase. On the issuance side, the region's infrastructure needs are large and will likely need to draw on cross-border investors. It is not clear that this expansion can be handled by the international rating agencies alone, since their universe is much broader. There may be room for market specialization in offering the finer regional gradations that both inter- national and regional investors may need as this segment grows. Under what scenarios could a regional credit-rating agency be viable? A study commissioned by the World Bank and undertaken by the rating agency CRISIL looked at the potential viability of such a rating agency. The study looked at the potential profitability of the rating agency, assuming that the agency were to undertake both rating and advisory services. Key factors for success would include: · Adequate business size and high capital levels; · High-quality governance; · Staff with adequate expertise; · Support of the respective sovereigns in the region; · Buy-in from international and domestic rating agencies active in the region; and · Independence (and the perception thereof) from political pressures. As regards ratings, cross-border issues in the region would be the predominant business opportunity. Cross-border issues could be rated on a regional scale that could encompass (1) issue ratings for sovereigns, state-owned entities, cor- porate entities, banks, and structured finance instruments; (2) issuer ratings for sovereigns; and (3) ratings for fixed income schemes of mutual funds. The other key business activity would be advisory services to enhance financial market integration. This could involve providing independent and credible benchmarking and valuation tools which would be in the nature of (1) co-relating local scale ratings in two different economies; (2) setting widely acceptable standards for the valuation of bonds; and (3) offering consulting services to domestic rating agencies to enhance the scope and rigor of their ratings. The potential profitability of a regional rating agency was examined under several scenarios of market share and cap- italization. The process involved estimating regional cross-border issuance and projected growth over the next five years; projecting the market share of the agency in cross-border issuance; estimating rating fees; estimating revenues from advisory services; estimating all cost elements; and projecting financial statements. The size of the bond market in the region was estimated at US$1.5 trillion in 2004. The study assumes that this mar- ket will grow at 14 percent annually to reach US$2.9 trillion in 2009. This growth is expected to be driven by structured finance issuances (with expected annual growth rate of 24 percent); infrastructure investments in these economies; is- suance of bonds by multilaterals, and continued improvements in the regulatory environment and bond market infra- structure. Cross-border issuance is projected to grow at an annual average rate of about 30 percent, with issuance volumes increasing from US$75 billion in 2004 to US$281 billion in 2009. The largest potential markets are expected to be Korea, followed by Malaysia and China at the end of 2009. (Continued) 42 East Asian Finance BOX 2.3 Rationale and Feasibility of Setting Up a Regional Credit-Rating Agency (Continued) Three different scenarios of market share were assumed: a market share of 10 percent after Year 5 of establishing the rating agency; a market share of 7.5 percent after Year 5 (base case), and a market share of 5 percent. Three different lev- els of initial capitalization were also examined: US$15 million, US$25 million (base case), and US$40 million. Thus nine different scenarios were examined altogether. In four of the scenarios, the rating agency would make profits from Year 4 onward. These are the scenarios of all three levels of capital (US$15 million, US$25 million, and US$40 million) with a 10 percent market share at the end of Year 5, and the scenario of US$40 million of capital with a market share of 7.5 percent at the end of Year 5. In the remaining five scenarios, the agency would make a profit starting in Year 5. As the table below shows, in the base case of 7.5 percent market share and US$25 million in initial capital, the rate of return on investment would be 20.7 percent. Scenario Analysis--Profitability Matrix (rate of return on investment in year 5) Market share in year 5 Initial capital 10 percent 7.5 percent 5 percent US$40 million 22.7 14.8 8.1 US$25 million 33.4 20.7 10.0 US$15 million 52.4 31.1 13.4 Arguably, the most important factor for success would be to ensure that the credit-rating agency enjoys full credibil- ity. In particular, the shareholder structure would need to follow certain key principles, namely: · Shareholders should be seen as credible and fostering independence of operations; · Shareholding should be widely dispersed (and fortified by a strong shareholders' agreement); · The maximum shareholding by a single entity should be limited to say 5­10 percent, unless the shareholder is an independent third party such as a rating agency or multilateral agency; · A balanced regional representation in the shareholding structure would be essential. Potential shareholders for the regional credit-rating agency could be as in the figure below: International rating agencies Domestic institutional Multilateral agencies investors (e.g., pension funds) Potential shareholders Banks and financial institutions operating Stock exchanges in the region Other market players (e.g., domestic rating agencies, mutual funds, insurance companies, brokerage houses, etc.) Regional Cooperation as a Means to Diversify Financial Markets 43 also be merit in considering regional mechanisms for at the domestic level. This is because the necessary sharing credit information. Such a mechanism--the deepening and diversification of markets largely Western Hemisphere Credit and Loan Reporting depends on actions at the domestic level and also Initiative--has recently been put in place in Latin because the benefits of regional initiatives them- America, including the development of a common selves depend on the complementary development assessment methodology and comparable reports. of domestic markets. The arguments that encouraged that region's adop- Indeed, while regional initiatives have helped iden- tion of a common regional approach were that it tify and remove several of the direct barriers to cross- would help countries that share similar difficulties border bond investments, cross-border bond flows in credit reporting to share knowledge, and that it (especially among the "developing" East Asia eco- would facilitate change in individual countries and nomies) remain quite small. Partly this reflects differ- lay the groundwork for future regional cooperation. ences among countries in areas such as credit-rating (It is often the case that regional projects create peer standards, legal and regulatory systems, and account- pressure for countries to improve their systems.) In ing and auditing standards and practices; these dif- the European Union, publicly operated centralized ferences add to costs and uncertainty for both issuers credit risk registries share their data across country and investors and can deter cross-border flows. Partly, borders to help supervisors to assess risk concentra- too, it reflects the fact that the region's institutional tions and connected lending. Countries in East Asia investor base is still quite small. The regulatory, gover- may also wish to consider such a regional approach, nance, and risk-management frameworks of institu- given the importance of credit-information infra- tions such as pension funds and insurance companies structure in enhancing access to finance. need to be strengthened to ensure these institutions have the incentive and ability to undertake cross- border investments. Domestic derivatives markets Both Regional and Domestic also need to be further developed and deepened, be- Policy Measures Are Needed cause limitations in this regard can reduce investors' While regional cooperation can play an important interest in cross-border investments. All these mea- role, the bulk of the policy measures needed to sures and actions need to be undertaken at the domes- deepen and diversify markets will have to be taken tic level. Building Better 3 Institutional Infrastructure The provision of accurate As is well known, financial markets are inherently subject to informational asymmetries. Funds are made available today and timely information, in the expectation of returns in the future, in a context of lim- the exercise of corporate ited and unequal information both with respect to the charac- governance, and appro- ter of the borrower (or insider)--leading to potential problems of adverse selection33--and with respect to the borrower's priate risk taking (risk subsequent behavior--potentially creating problems of moral management) are core hazard.34 attributes of well- Where it is costly to acquire information and enforce the rights of finance providers, financial markets can never be fully functioning financial efficient and arbitraged. Thus, the generation and dissemina- systems. These in turn tion of reliable and timely information, and the effective exer- need to be supported by cise of corporate governance at all levels, so that funds can be extended productively with an appropriate degree of risk tak- two key institutional ing, are core attributes of well-functioning financial systems underpinnings: effective (Figure 3.1). legal and regulatory In turn, these core attributes are shaped by deeper institutional underpinnings. Key among these underpinnings are a country's framework and practices, legal framework and practices and incentive-compatible pruden- and good accounting and tial regulations (specific to particular financial segments), because these features shape the extent of disclosure that is required of firms auditing standards and and financial intermediaries as well as the rights of shareholders practices. The East Asian and creditors to act upon the information they obtain. Also fun- countries have made damental are the country's accounting and auditing standards and practices, because these determine the quality of the information considerable progress in being disseminated. strengthening regulations These underpinnings have an important bearing on the func- and standards--focus is tioning of all financial segments and markets and are discussed in this chapter, with a focus on the following questions:35 now needed on effective implementation. Where do countries in the region stand with respect to infor- mation disclosure and to the exercise of corporate governance more broadly? Which aspects of the key institutional underpinnings-- shareholder rights, creditor rights and insolvency regimes, and accounting and auditing--should countries concentrate on strengthening? 45 46 East Asian Finance FIGURE 3.1 Core Attributes and Underpinnings of Well-Functioning Financial Systems Agents Market institutions Structure Investors money, bond, and equity markets exchanges Financial clearance and settlements Corporations Supervisors institutions dealers' associations credit bureaus Depositors credit rating agencies Creditors Core attributes of a Information well functioning financial system Corporate governance Appropriate risk taking Key · accounting and auditing systems and practices institutional · legal framework and practice (including insolvency regime) underpinnings · incentive-compatible prudential regulation and supervision Source: Author. h The Exercise of Corporate Governance: tries in East Asia stand with respect to the key elements An Overview of corporate governance. Rules and regulations per- taining directly to the exercise of corporate governance The exercise of corporate governance is important are seen to be weakest in China, Indonesia, and the both for firms' access to finance (see Chapter 5, Box Philippines. Enforcement is seen to be more widely 5.5) and for the growth and stability of financial sys- problematic--particularly in Indonesia, the Philip- tems. Since the health of the financial system depends pines, and Thailand. But even in the Republic of Korea on the underlying soundness of its individual com- and Malaysia, whose scores are higher, the market sees ponents and its linkages, good corporate governance is room for improvement. In accounting and auditing, important at all levels: firms (by shareholders, credi- China and Indonesia are seen to be the furthest from tors, and other stakeholders); financial intermedi- international standards and practices. In China, while aries (by shareholders, creditors, supervisors, and the government's policy is to bring local accounting the market); and regulators and supervisors them- standards into line with international standards, there selves (by governing bodies and the public). are significant discrepancies at present. Indonesia is The effective exercise of corporate governance much closer to international standards, but still has depends on the degree and quality of information dis- some differences. The last column of Table 3.1 reflects closure, and on the incentives and ability of providers the market's rating of the overall corporate governance of external finance and other stakeholders to act on culture, as manifested by the degree to which institu- the information disclosed. In turn, these factors are tional and retail investors actively promote good shaped by the legal framework and its enforcement, corporate governance. Here again, China, Indonesia, by the quality of accounting and auditing standards and the Philippines are seen to be the weakest. and practices, and by the overall corporate gover- nance culture or practice. Disclosure and transparency from The importance of corporate governance has in- the perspective of shareholders creasingly been recognized and, over the past few years, countries in the region have made significant Given the problems of asymmetric information efforts to strengthen the various elements that shape it. that are inherent in the financial sector, the gener- Table 3.1 shows market perceptions of where coun- ation and dissemination of reliable information on Building Better Institutional Infrastructure 47 TABLE 3.1 Corporate Governance Scores--A Market Perspective Rules and Political and Corporate Economy Economy regulations Enforcement regulatory IGAAP governance culture score China 5.3 4.2 5.0 7.5 2.3 4.8 Indonesia 5.3 2.7 3.8 6.0 2.7 4.0 Malaysia 7.1 5.0 5.0 9.0 4.6 6.0 Rep. of Korea 6.1 5.0 5.0 8.0 5.0 5.8 Philippines 5.8 3.1 5.0 8.5 3.1 5.0 Thailand 6.1 3.8 5.0 8.5 3.5 5.3 Hong Kong (China) 6.6 5.8 7.5 9.0 4.6 6.7 Singapore 7.9 6.5 8.1 9.5 5.8 7.4 Source: Credit Lyonnais Asia Pacific 2005. Notes: Score ranges from 1 (lowest) to 10 (highest). IGAAP = international generally accepted accounting practices. The assessments are based on a number of parameters under each category, as listed in the source of this table. a timely basis is of vital importance in improving the An analysis by Standard and Poor's (2005) of a efficiency of financial markets and in reducing sys- sample of listed financial and non-financial firms in temic vulnerability. The Organisation for Economic 2005 shows the extent to which key corporate gov- Co-operation (OECD) principles of good gover- ernance aspects are disclosed in the firms' annual nance suggest that firms should disclose all material reports (Figure 3.2). Here again, firms in Singapore information (including their financial and operat- and Hong Kong (China) score the best on average, ing results; their objectives; their major share own- although there is quite a large range in the perfor- ership and voting rights; their remuneration policy mance of firms in Singapore (largely reflecting the for members of the board and key executives; infor- performance of firms that are incorporated outside mation about board members; related-party trans- Singapore), followed by Malaysia, Korea, Thailand, actions; foreseeable risk factors; issues regarding and Indonesia, in that order. The analysis did not employees and other stakeholders; and governance cover China or the Philippines. structures and policies); that this information be prepared and disclosed in accordance with high Information disclosure by top five banks standards of accounting and financial and nonfi- Given the importance of banks from the perspective nancial disclosure; and that the results be audited of systemic risk, this section looks in more detail at annually by an independent, competent auditor. the scope of financial disclosure practiced by the top five banks (selected by size of assets) in each country Disclosure by listed firms in the region. Except in China and the Philippines, To what extent do firms actually practice disclosure? the scope of disclosure by these banks is relatively To a large extent the degree, quality, and timeliness of broad (Table 3.2), and indeed, the top banks in information disclosure rests on the enforcement of Singapore rank higher than banks in Germany, the legal framework--the company law, the com- Japan, the United Kingdom, or the United States. mercial law, the civil code, and the statutory require- However, disclosure tends to be more limited within ments under each of the relevant prudential and certain categories, notably the details of the maturity supervisory bodies (such as, for instance, the Securi- structure of liabilities; foreign-exchange exposure; ties and Exchange Commission (SEC) for SEC-listed derivatives breakdowns; loans made to related parties companies)--and on prevailing accounting and au- (included under "other" items); and risk-weighted diting standards and practices. However, it also de- assets, contingent liabilities, and capital ratios (tier 1, pends on the overall corporate-governance culture. 2, 3, total and risk-weighted), which are grouped Thus in many cases, corporations and banks--at least within the "memo" items. the larger ones--may be following international best Two caveats also need to be noted. First, in most practice even if the prevailing rules and regulations countries, the largest banks are likely to follow con- are less stringent. siderably higher standards than the smaller banks. 48 East Asian Finance FIGURE 3.2 Disclosure Practiced by Listed Firms a. Indonesia b. Malaysia se 12 18 mean 23.79 16 mean 64.92 ani 10 standard deviation 13.35 14 standard deviation 11.85 8 12 ompcforeb 10 6 8 4 6 4 2 2 num 0 0 10 50 0 0 00 0 0 10 0 0 0 00 10 20 0 0­ 0­ ­ 11­20 ­30 ­4041­ 21 31 51­6061­771­8081­991 110 ­ 1­1101­1201­131­14 11 11 12 13 ­20 ­30 ­4041­5051­6061­771­881­991 110 111 112 13 21 31 1­ 1­ 1­ 1­140 13 scores scores c. Thailand d. Hong Kong, China 16 10 se 14 mean 42.57 mean 42.75 8 ani 12 standard deviation 19.85 standard deviation 19.85 mpocforeb 10 6 8 6 4 4 2 2 num 0 0 10 40 50 0 00 0 10 0 0 0 00 10 20 0 0­ ­20 ­30 ­ 11 21 31­ 41 51 ­6061­7071­8081­991 110 ­ 1­1101­1201­131­140 0­ 11 11 12 13 ­20 ­30 ­4041­5051­6061­771­881­991 110 111 112 13 21 31 ­ 1­ 1­ 1­ 1­140 13 scores scores e. Singapore se 16 14 mean 80.58 ani 12 standard deviation 28.57 10 ompcforeb 8 6 4 2 num 0 10 0­ 11­20 ­30 ­4041­5051­6061­771­8081­991 110 111 112 13 0 0 00 10 20 21 31 ­ 1­ 1­ 1­ 1­140 0 13 scores Source: Standard and Poor's 2005. Second, this analysis covers only the extent of dis- related to corporate governance. What is needed is closure, not its quality. to enforce these rules and to cultivate a culture of To sum up, the disclosure practices of a sample greater disclosure over time. of listed firms and banks suggest that the timeliness of regular reporting seems to be relatively good across countries in the region. However, the scope and qual- Availability of information from ity of the information being disclosed still needs to the perspective of creditors be improved, particularly in China, Indonesia, and For banks and other financial institutions, informa- the Philippines. It is important that firms disclose tion sharing through credit bureaus or credit registries all relevant and material information, rather than can significantly expand the amount of information practicing the somewhat selective disclosure that available on borrowers, whether firms or private con- seems to be relatively common. Most countries sumers. Credit information systems can fulfill a num- have put in place rules and regulations on disclosure ber of functions including collecting, analyzing, and Building Better Institutional Infrastructure 49 TABLE 3.2 Disclosure by Top Five Banks in Each Jurisdiction (Percent) Hong Kong Economy China Indonesia Korea Malaysia Philippines Thailand (China) Singapore Assets 0.73 0.92 0.97 0.83 0.79 0.88 0.90 1.00 Liabilities 0.73 1.00 1.00 0.67 0.83 0.87 1.00 1.00 Funding 0.67 0.67 1.00 0.67 0.83 1.00 0.89 1.00 Memo 0.60 0.71 0.71 0.89 0.44 0.78 0.72 0.78 Income statement 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 Other 0.67 0.71 0.86 0.76 0.61 0.69 0.81 0.89 Total 0.69 0.81 0.88 0.81 0.68 0.83 0.85 0.92 Source: World Bank staff calculations based on banks' annual reports. Note: The table shows the scope of information disclosure by the top five banks in each country regarding: (1) their asset composition--maturity structure breakdown, breakdown of loans by type, breakdown of loans by counterparty, total nonperforming loans (NPLs), asset quality, securities by type and securi- ties by purpose; (2) their liabilities--maturity structure; (3) their funding sources; (4) memo items such as reserves, capital ratios, risk-weighted assets break- down, or contingent liabilities; (5) details in their income statement--aggregate non-interest income, loan-loss provisions; and (6) and details of other items such as foreign-exchange exposure, derivatives breakdown, business segment, nonperforming loans by type (restructured, write-off), days of credit, or non- performing loans past due, movement of provision on impaired assets, and loans made to related parties. The numbers are the average score of the top five banks in each country for each of the six categories, divided by the maximum obtainable score for each category. Thus, a figure of 1.0 indicates that the maximum obtainable was achieved. Note that the table does not incorporate an assessment of the quality and reliability of the information disclosed--simply its scope. distributing information about how consumers and creditors have the right to act on the information businesses handle their credit obligations. This type of provided. Box 3.2 outlines the OECD best-practice information has proved to be an effective tool for a principles for corporate governance, including those range of purposes, including assessing the risks faced relating to shareholders' rights. by creditors. Reviews of standards and codes that were under- Credit information systems also make it possible taken for Indonesia, Korea, Malaysia, the Philippines, to assess empirically, through the use of credit- and Thailand show where countries stand with regard scoring tools, which factors are most predictive of to the OECD principles on the rights of shareholders default. As a result, creditors can more intelligently and the responsibilities of boards (Table 3.4). assess loan requests from consumers and businesses, Basic shareholder rights are in place in all the and will be more likely to extend credit where it can crisis-affected economies and in Hong Kong (China) be productively used. Credit information systems and Singapore. China has recently amended its Com- also promote competition among lenders, thereby pany Law, with several amendments relating to a reducing the cost of credit. strengthening of shareholder rights (Box 3.3). Credit bureau information is especially useful for However, the rules relating to the effective partic- financial institutions deciding whether to lend to in- ipation of shareholders, and particularly that of mi- dividuals and smaller companies. While lending to nority shareholders, have room for improvement. large companies requires a detailed analysis of the potential borrower's financial standing, for smaller For instance, in Thailand, the minimum number of loans, payment history is found to be a sufficiently days required for notifying shareholders of meetings good predictor of the probability of default. is only seven (14 days' notice are required for an ex- Box 3.1 summarizes some key features of well- traordinary shareholders' meeting). In Malaysia, the functioning credit information systems, and Table 3.3 Philippines, and Thailand, proxy voting is allowed, shows the status of credit reporting and financial in- but voting by mail is not. The threshold of owner- formation infrastructure in the region. ship that gives a shareholder the right to place items on the agenda in a shareholders' meeting varies con- siderably among countries, from one third of the Shareholder Rights, Board company's issued shares in Thailand to only 1 per- Responsibilities, and Their cent of the company's shares, owned for six months, Implementation in Korea. The ownership threshold for requesting an Timely and relevant information is necessary, and extraordinary shareholders' meeting also varies: from it is also clearly important that shareholders and 3 percent of a company's voting rights (in Korea), to 50 East Asian Finance BOX 3.1 Key Elements for Well-Functioning Credit Information Systems Key requirements. A clear legal and regulatory framework allows credit reporting to function successfully. Governments can promote a supportive environment for credit bureaus by enacting and enforcing laws that ease the sharing of credit information. Relevant laws include bank secrecy regulations, data protection laws, and consumer protection provisions. Two concerns that must be addressed with regard to collection and distribution of personal data are privacy and access. Confidence in secure, protected credit information creates more support for credit-registry systems. Laws regulating credit reporting should allow credit information to be shared while protecting the legal rights of individuals and firms. Undue restrictions on information sharing, for example through unnecessarily severe penalties and sanctions or complicated and expensive procedures, may discourage firms from entering the credit-reporting business. Policymakers may choose between using laws to regulate the industry or cultivating a self-regulating code of conduct. Laws and regulations must protect consumers and ensure that data are not misused, by creating a balance of privacy protection and effective infor- mation sharing. The purpose of laws and regulations governing credit reporting is to allow responsible sharing of credit information. Typically time limits are imposed on the inclusion of adverse credit information. In addition, laws should safeguard consumer rights by allowing consumers to obtain their own credit reports and by providing appropriate dis- pute-resolution mechanisms to correct erroneous information. Scope of coverage. For credit bureaus to assess risk accurately, they must gather information on a timely basis and share both positive and negative information. They should include data from all lenders, including other non-bank financial institutions, retail firms, and non-financial firms that issue credit. Their goal should be to broaden access to credit and reduce financial risk--a goal that requires a complete borrowing profile. Ownership. Credit registries may be established in the private or public sector or operate as a joint venture between the state and member banks, or between member banks and foreign private bureaus. Public and private credit registries are often found to be complements, not substitutes. Public registries are usually established by the central bank and serve the dual purpose of improving a bank's risk management and strengthening bank supervision. One advantage of public registries is that they can usually set up operations quite rapidly, since they usually rely on regulations established by the central bank that require all supervised financial institutions to submit data. Hence public registries can overcome prob- lems of non-compliance. Private registries, for their part, are able to collect information from a larger number of sources, ranging from financial institutions to entities that sell goods on credit. Private registries can also provide a wider range of services, including investigative reports as well as value-added services such as credit scores and ownership links. Since par- ticipation is voluntary however, these registries may, at least initially, not cover all financial institutions. Also, private reg- istries tend to maintain only negative information--since financial institutions may only be willing to share negative information voluntarily, for fear of revealing the identity of their best customers to competing financial institutions. Pub- lic registries typically cover positive information. Nonetheless, since private bureaus are better designed to collect and distribute information to lenders, most developed countries have a private credit-reporting system, even though many also have a public registry operating at the central bank. 20 percent of the company's issued shares or at least changes in control are rare, as the rules are very cum- 25 shareholders holding 10 percent of the company's bersome. In Thailand, too, hostile takeovers are made issued shares (in Thailand). In most countries, share- extremely difficult by company ownership structures. holders have the right to make fundamental deci- In the Philippines, takeovers are impeded by anti- sions such as approving the appointment of directors takeover devices, which shield management from ac- and auditors36 and approving major corporate trans- countability to all shareholders. Best practice would actions. However, cumulative voting for directors is dictate that anti-takeover devices be adopted only if not permitted in Malaysia, and though this principle minority shareholders approve them and consider is permitted in the other countries, it is often negated them to be in the company's best interest. by companies' articles of association. One of the principles of good governance is that The exercise of good corporate governance also shareholders of the same class be treated equitably. requires efforts to ensure that the market for corporate Adherence to this principle could be strengthened control functions well. This is an area that needs to be in several countries. In Indonesia, for example, the addressed particularly in Indonesia, the Philippines, Company Law does not explicitly require the board and Thailand. In Indonesia, transactions resulting in to treat all shareholders of the same class equally. In Building Better Institutional Infrastructure 51 TABLE 3.3 Infrastructure for Credit Reporting and Financial Information Rep. of Hong Kong China Indonesia Korea Malaysia Philippines Thailand (China) Singapore Elements of financial information infrastructure Public registry Yes Yes Yes Yes No No N/A N/A Private credit bureau Noa Yes Yes Yes Yes Yes Yes Yes Corporate registry Yes-E Yes Yes-E Yes-E Yes-E Yes-E Yes-E Yes-E Collateral registry-- No Yes-E Yes-E Yes-E Yes No N/A N/A fixed assets Collateral registry-- No Yes-E Yes No No No N/A N/A moveable assets Court records Yes Yes Yes-E No Yes-E Yes N/A N/A Legal framework Yes Yes Yes-L Yes Yes Yes-L N/A N/A Scope of information Both consumer and No Yes No Yes Yes Yes Yes No firm data Both banking and Yes No Yes Yes Yes Yes No Yes real sector data More than 5 years Yes No No Yes No No No Yes of data for distribution Both positive and No Yes Yes Yes Yes Yes Yes Yes negative information Source: World Bank. Notes: With regard to corporate registry and court records, "Yes" indicates the existence of such an institution and "Yes-E" indicates that the information con- cerned is available in electronic format. With regard to legal framework, "Yes" indicates that consumers/firms have rights to inspect their data; "Yes-L" indi- cates the existence of a credit-reporting law. a. Private bureau data in China come from a regional credit database managed by a private firm. Note however that a consumer-credit-reporting system, ini- tiated by the Peoples' Bank of China in 2004, was put into use in 2005 in 15 nationwide commercial banks and 8 city commercial banks, and is expected to link all major commercial banks and rural credit corporations by mid-2006. BOX 3.2 Summary of OECD Corporate Governance Principles Rights of shareholders and key ownership functions. The corporate governance framework should protect and facilitate the exercise of shareholders' rights. Equitable treatment of shareholders. The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights. Disclosure and transparency. The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including its financial situation, performance, ownership, and governance. Responsibilities of the board. The corporate governance framework should ensure the strategic guidance of the com- pany, the effective monitoring of management by the board, and the board's accountability to the company and the shareholders. Source: OECD 2004. 52 East Asian Finance TABLE 3.4 Assessments of Shareholder Rights and Board Responsibilities Indonesia Rep. of Korea Malaysia Philippines Thailand Rights of shareholders Basic shareholder rights 3 4 4 4 4 Rights to participate in fundamental decisions 4 5 4 4 3 Shareholders' annual general meeting rights 4 4 4 3 4 Disproportionate control disclosure 2 4 3 5 4 Control arrangements allowed to function 2 4 4 2 3 Equitable treatment of shareholders All shareholders treated equally 3 4 4 4 3 Prohibition of insider trading 3 3 4 4 4 Board/managers disclose interests 3 3 4 3 4 Board responsibilities Board should act in good faith, with due 3 4 3 2 3 diligence and care Board should treat all shareholders fairly 3 3 4 4 4 Board should apply high ethical standards 3 3 3 4 3 and look to the interests of all stakeholders Board should fulfill key functions 3 4 4 2 3 Board should be able to exercise objective, 3 3 4 1 3 independent judgment Board should have access to accurate, timely, 3 3 4 2 4 and relevant information Source: Reports on the Observance of Standards and Codes that are undertaken by the World Bank and IMF at the request of member countries. Note that the reviews underlying these reports have taken place over a period of time: Philippines September 2001; Indonesia August 2004; Korea September 2003; Malaysia June 2005; and Thailand June 2005. Notes: Scores range from 1 to 5; 5 = observed; 4 = largely observed; 3 = partially observed; 2 = materially not observed; and 1 = not observed. BOX 3.3 Selected Amendments to Corporate Governance in China's Company Law China's revised Company Law was approved by the National People's Congress in October 2005. The law reinforces the fiduciary duties of directors and other corporate insiders and enhances public shareholder rights and access to informa- tion. In particular: · A controlling shareholder, director, or senior manager who takes advantage of his or her affiliation and impairs a com- pany's interest may be liable for damages. · Cumulative voting is allowed. · The revised law introduces a mechanism to "pierce the corporate veil" to protect a creditor's interests. Henceforth, "if any shareholder of a company causes any losses to the company or any other shareholder as a result of abuse of its shareholder rights, it shall make compensation for such losses." · A shareholder may ask the court to set aside board or shareholder resolutions that violate any law or regulation, or the company's articles of association. · A shareholders' meeting may be called by shareholders who, in the case of a joint stock company, have held 10 per- cent of more of the company's total shares for 90 consecutive days. · Shareholders have the right to examine and copy articles of association, minutes of shareholders' meetings, board resolutions, and financial and accounting reports. · Employee representatives must make up at least one third of a company's board of supervisors. Sources: China Quarterly Update, February 2006. World Bank. Building Better Institutional Infrastructure 53 Thailand, the Public Company Act provides that the the controlling shareholders of a firm tended to hand- rights of preferred shareholders may not be modi- pick its executive, inside directors. Since the financial fied (for example by converting preferred to ordi- crisis, a high priority has been placed on restructur- nary shares) unless this possibility is specified under ing corporate boards, including mandating outside the company's articles of agreement. But the hold- directors and various committees (for nomination ers of other classes of shares that may be negatively and remuneration of directors, and for audit) and affected by a proposed action, or that have a special requiring directors to be more accountable to all interest in the matter, are not eligible to vote, even shareholders. Under good principles of corporate on a modification of their rights. governance, boards are expected to act in good faith, The prohibition of insider trading and abusive with due diligence, and in the best interests of the self-dealing is clearly important for the equitable company and the shareholders. Where board deci- treatment of all shareholders. Any self-interest on sions may affect different shareholder groups differ- the part of the board or management should also ently, they are required to treat all shareholders fairly. be disclosed to other shareholders. These are areas Boards are expected to apply high ethical standards that need attention in several countries, including and to fulfill certain key functions including select- Indonesia, Korea, and the Philippines. In Indonesia, ing, compensating, monitoring, and replacing key the problem stems from weak enforcement of insider- executives; ensuring a formal and transparent board- trading rules and from legal uncertainty with re- nomination process; and monitoring and managing spect to related-party transactions--with no explicit potential conflicts of interests of management, board rule for directors to disclose related-party transac- members, and shareholders. The board is expected to tions. In Korea, related-party transactions are wide- be able to exercise objective and independent judg- spread, and because they often involve controlling ment on the corporation's affairs and have access to shareholders or affiliated persons, they are not cov- the information necessary to do so on a timely basis. ered by the Commercial Code. Under Korea's Secu- Countries in the region, especially Indonesia, the rities and Exchange Act, which was revised in 2001, Philippines, and Thailand, adhere weakly to one or a large listed firm is required to get board approval several of these principles. In the Philippines, com- and report to the general shareholders' meeting pany boards are not very effective at selecting, mon- a transaction with the largest shareholder or its af- itoring, or replacing key managers; their role needs filiate. A rule of similar content is included in to be strengthened. Also, Philippine law does not re- Korea's Monopoly Regulation and Fair Trade Act. quire that tasks involving potential conflicts of in- Korea's Commercial Code already bars directors terest (such as remuneration or financial reporting) facing potential conflicts of interest from voting in be given to independent directors. In Thailand, the a directors' meeting. However, conflict of interest Public Company Act does not establish specific func- is narrowly defined and inside directors are often tions for the board, although the general powers and allowed to vote. Korean policymakers may want to responsibilities of boards are broad enough to en- consider strengthening rules to impede self-dealing compass all major decisions that are not subject to and insider trading--for example, by excluding in- shareholders' approval. In practice, boards in Thai- side directors from decisions involving potential land tend to limit themselves to hiring, discharging, conflicts of interest. In the Philippines, the law con- and determining the pay of the chief executive officer tains requirements for disclosure and shareholders' or president, rather than all key executives. In In- approval for the board and managements' related- donesia, the Company Law provides that a limited- party transactions, but there is some concern that liability company must have a two-tier board system these requirements may not be consistently adhered composed of a board of directors (BOD) and a board to, in an environment of pyramid structures and of commissioners (BOC); the BOD is in charge of majority shareholder control with family dominance. day-to-day management of the company, and the The responsibilities of boards of directors could be BOC has the duty of monitoring, overseeing, and strengthened in most of the countries. Boards of advising the BOD. Responsibility for the selection directors monitor and provide strategic guidance of managers, strategic guidance, and protection of to the management of a firm and are a key corporate shareholder rights would fall largely to the BOC, governance mechanism for shareholders. In the past, as provided by the rules of the Jakarta Stock Exchange 54 East Asian Finance (except that the BOC does not appoint the members audit committee has significantly improved the in- of the board of directors).37 The Jakarta Stock Ex- dependence of directors in listed companies. Thai- change rules specifically require listed companies to land's Securities and Exchange Commission specifies establish audit committees, but do not mandate the required qualifications for independent directors, use of committees for directors' remuneration and but in companies where a controlling shareholder nomination. also assumes the role of a director or senior execu- In Korea, under the Corporate Code, manage- tive, his independence may be doubtful. ment is not allowed to discriminate among share- Another important aspect in the exercise of holders of the same class, and the board is subject corporate governance is the extent to which share- to the duty of care. However, as long as all share- holders can seek redress if their rights are violated. holders are treated equally in a formal sense, the This option remains limited in most countries. In board is entitled to take any action. For example, Malaysia, the Company Act provides remedies for a firm may forgo paying dividends or undertake a aggrieved shareholders, but investors have only a rights offering of a substantial size, as those deci- limited ability to take action against directors who sions apparently affect all shareholders equally. It have breached their fiduciary duties; there are no is very difficult to attack such a decision by a board specific provisions for derivative suits or class-action on the grounds of violation of duty of care, and in suits. In the other countries of the region, derivative most cases a board decision would be respected by suits are allowed--albeit subject to different thresh- the courts. olds of share ownership, ranging from shareholders Boards' ability to exercise objective and indepen- owning more than 0.01 percent of the company's dent judgment and their access to timely informa- shares in Korea to those owning at least 10 percent tion in order to fulfill their duties are key issues in of the company's shares in Indonesia. Class-action almost all the countries studied. In Indonesia, the suits are allowed in Indonesia, but are costly, and Company Law does not require the members of the have just been introduced in Korea for companies BOC to be independent, although the Jakarta Stock with assets of more than two trillion won. They are Exchange regulations now require listed companies also allowed in the Philippines, filed either at the to fill at least one third of the BOC with independent Securities and Exchange Commission or regular commissioners. In practice, shareholders have no courts depending on the violation. In Thailand, the mechanism to select or nominate independent com- introduction of class-action suits is pending: the missioners; the general shareholders' meeting nor- Class Action Act now in draft would enable share- mally approves the BOD's proposal for independent holders and investors to sue directors, managers, au- commissioners. Indonesia's Company Law is also ditors, and relevant parties for breach of their duties not explicit on the BOC's access to corporate infor- and with much less concern about the costs. How- mation; since it empowers the BOC to supervise and ever, this law may take some time to be enacted. advise the BOD, it implies that the BOC can require and access any corporate information needed to ful- Creditors' Rights and fill this responsibility. In practice, however, members Their Implementation38 of boards of commissioners are not aware of their rights and responsibilities. In Korea, the Stock Ex- From the perspective of creditors, rights to enforce change Act requires a listed company to appoint at both secured and unsecured claims through efficient least one quarter of its directors from outside the mechanisms outside of insolvency, as well as through company. The degree of independence of these out- a sound insolvency system, are key. It is also impor- side directors was unclear in the past, but this is grad- tant that the mechanisms other than insolvency, and ually changing. In the Philippines, legal provisions the insolvency regime, be designed to work in har- exist to protect directors' right to question informa- mony with each other. Box 3.4 summarizes the prin- tion provided by company management, but market ciples and guidelines for effective insolvency and participants consider that this right is undermined creditor rights based on the World Bank's Principles by the appointment of many directors by controlling and Guidelines for Effective Insolvency and Creditor shareholders. In Thailand, the requirement for an Rights Systems.39 Building Better Institutional Infrastructure 55 BOX 3.4 Principles and Guidelines for Effective Insolvency and Creditor Rights Security interest legislation should provide for the creation, recognition, and enforcement of security interests in prop- erty, arising by agreement or operation of law. It should provide for: · The creation, recognition, and enforcement of security interests in all types of assets--movable and immovable (real), tangible and intangible, including inventories, receivables, proceeds, and future property, and on a global basis, including both possessory and non-possessory interests. · Any or all of a debtor's obligation to a credit, present or future, and to all types of persons. · Methods of notice that will sufficiently publicize the existence of security interests to creditors, purchasers, and the public, at the lowest possible cost. · Clear rules of priority on competing claims or interests in the same assets, eliminating or reducing priorities over security interests as much as possible. Recording and registration of secured rights. There should be an efficient and cost-effective means of publicizing secu- rity interests in movable and immovable assets, with registration being the principal and strongly preferred method. Access to the registry should be inexpensive and open to all for both recording and search. Enforcement of secured rights. Enforcement systems should provide efficient, inexpensive, transparent, and predictable methods for enforcing a security interest in property. Enforcement procedures should provide for prompt realization of the rights obtained in secured assets, ensuring the maximum possible recovery of asset values based on market values. Both non-judicial and judicial enforcement methods should be considered. Corporate insolvency legislation should: · Maximize the value of a firm's assets by providing the option to reorganize. · Strike a careful balance between liquidation and reorganization. · Provide equitable treatment of similarly situated creditors, including similarly situated foreign and domestic creditors. · Provide for timely efficient and impartial resolution of insolvencies. · Prevent premature dismemberment of a debtor's assets by individual creditors seeking quick judgments. · Provide a transparent procedure that contains incentives for gathering and dispensing information. · Recognize existing creditor rights and respect the priority of claims with a predictable and established process. · Establish a framework for cross-border insolvencies, with recognition of foreign proceedings. · Provide for the implementation of the insolvency system. · Specify the role of courts. Bankruptcy cases should be overseen and disposed of by an independent court or compe- tent authority and assigned, where practical, to judges with specialized bankruptcy expertise. The law should provide for a court or other tribunal to have a general, non-intrusive supervisory role in the rehabilitation process. The court/ tribunal or regulatory authority should be obliged to accept the decision reached by the creditors that a plan be approved or that a debtor entity be liquidated. · Judicial decision making and enforcement. Judicial decision making should encourage consensual resolution among parties where possible, and otherwise undertake timely adjudication of issues with a view to reinforcing predictability in the system through consistent application of the law. The court must have clear authority and effective methods of enforcing its judgments. Security interest legislation that lenders be able to take security interests in future property, and on a global basis. And where a credit A sound framework for allowing secured lending40 provides for future lending or optional drawing (such can encourage the provision of credit and assist in as revolving facilities), the obligations should be the development of domestic financial markets.41 capable of being secured at the outset of the trans- The legal framework should provide for the creation, action. For tangible assets, the law should also per- recognition, and enforcement of security interests in mit both possessory and non-possessory security a broad category of assets--movable and immovable interests. In the case of security over chattels,42 re- (real), tangible and intangible. It is also important quiring the delivery of possession can be a serious 56 East Asian Finance impediment, since such chattels are typically held by are present should be considered, along with whether the debtor as equipment for use in his business or commercial secured lending is possible, whether title for sale as inventory. Giving possession to the cred- finance is possible, the nature of legal provisions itor would prevent the debtor from using or selling for home mortgages, the provisions for the transfer the chattels and generating the income needed to of secured claims, and the role of statutory priority service the debt. claims (such as those of government or employee It is also important to publicize the existence of creditors) relative to secured claims. the security interests, but to do so efficiently. The re- Creation of security interests quirement to specifically identify each item of col- lateral, still found in a number of legal systems, is In each jurisdiction covered, the legal system pro- cumbersome even when applied to existing assets, vides for real property to be offered and taken as col- and makes it very difficult to provide security over lateral. However, there are considerable differences future property, especially in the case of a global se- among these systems (Table 3.5), notably in the ease curity. It should suffice that the description of col- and efficiency with which mortgages, charges, or liens lateral is such that the asset over which security is may be created; the requirements for registration; asserted can be identified as falling within the scope whether the mortgagor retains title to the collateral of the security agreement. while the extension of credit that it purports to secure Finally, it is important that the security system remains outstanding; and how secured creditors may also set the rules of priority on competing claims or enforce their collateral rights. Differences also exist, interests in the same assets and minimize the num- in some cases, in the treatment of collateral arising ber of priorities that come ahead of secured interests from varying statutory provisions for real property in collateral. ownership by domestic and foreign interests. Therefore, in assessing a country's legislation on The treatment of secured rights over movable secured lending, the extent to which these elements property is still more varied across the region TABLE 3.5 Treatment of Real Property Economy Issues China Land may not be mortgaged but mortgages over land use are permitted. Registration is necessary to protect secured creditor rights. The enforcement of a mortgage can require litigation in cases where the mortgagee and the mortgagor cannot reach agreement as to how the mortgagee claim may be satisfied. Transactions involving mortgages to be held by foreign entities are subject to prior ap- proval and registration with the State Administration of Foreign Exchange. Indonesia Security interests may be taken in land but often prove difficult for creditors to enforce. Enforcement is clearly inefficient; it can take years. Auction fees and taxes are high and, in practice, recourse to the courts is almost always necessary. Official registries are maintained manually, which causes dif- ficulties for potential lenders wishing to search for title or prior claims. Rep. of Korea Most real-estate rights must be registered. However there are important exceptions from this rule (for example, property acquired through inheritance or pursuant to a judgment auction). Philippines Real property may be mortgaged and both registration and notarization are statutory requirements necessary for creditor protection. Ownership is retained by the mortgagor while a charge is out- standing. Delays in foreclosure can occur because the secured party must use the courts in the absence of any contractual agreement for extra-judicial foreclosure. Thailand Real property may be mortgaged and registration is necessary to protect the secured creditors' rights, but foreclosure cannot occur unless a loan interest or charges have been outstanding for five years. This provision contributes to an inefficient enforcement process that can last for decades. Malaysia, Hong Kong (China), All allow for a charge to be taken over land, which must be registered. Hong Kong (China) and and Singapore Singapore also provide for mortgages to be taken over land, but since 1984 the mortgage may be created only by a legal charge in Hong Kong (China). The Malaysian courts will generally recognize a charge that is executed but not yet registered. All three jurisdictions call for the appointment of a receiver to protect the creditor's interest, and in all three jurisdictions there is a high level of predictability and efficiency as to the creditor's ability to enforce its rights. Source: Arner and others 2006. Building Better Institutional Infrastructure 57 (Table 3.6). None of the jurisdictions has adopted future property or the use of security to collateralize a regime like that specified by the U.S. Uniform Com- future loans. mercial Code (UCC) Article 9,43 but the English- origin systems of Hong Kong (China), Malaysia, Registration of security interests and Singapore work relatively well for this purpose. It is important that a debtor's granting of security Delays and inefficiencies in the enforcement of se- interests be publicized, to allow third parties intend- cured rights are common in several jurisdictions. ing to acquire an interest in the asset to learn of a Limits to the movable assets that may be used as col- prior security in the asset, and to prevent the debtor lateral may be problematic or constraining in most from raising further credit on the strength of his ap- jurisdictions; they include bars to taking security in- parent ownership of the asset. And there is general terests in chattel paper or accounts receivable, and agreement that transferring possession of the assets more broadly a lack of provisions for charges over to the creditor as a means of publicity is inferior to TABLE 3.6 Treatment of Movable Property Economy Issues China Mortgages may be taken over existing movable property, but not over future property. Secured cred- itors must register their claims to protect all such non-possessory rights. They may also protect themselves though possession in the form of a pledge. As with real property, foreign entities seek- ing security over movable property must comply with the approval and registration procedures of the State Administration of Foreign Exchange. The treatment of security interests in intangible assets such as bank accounts or receivables is less straightforward. Regulations have been issued allowing mortgages over such assets, but the effectiveness of these new forms of col- lateral is largely untested. Enforcement of unsecured claims can sometimes run into resistance at the local level; instances have been reported in which banks and their clients have colluded to hide assets from the court. Indonesia Under the Fiduciary Security Law, a debtor may transfer title to goods to a creditor and retain pos- session of the goods in the absence of any default. Pledges are also permitted. A fiduciary assign- ment may be taken for security purposes over intangible property and receivables. As with real property, enforcement over movable property requires recourse to courts and both auction fees and taxes are punitive. In essence, secured creditors foreclosing on collateral are forced to resort to substantially the same court proceedings as unsecured creditors. Rep. of Korea Rights in personal property may only be protected by possession. Korean law does not recognize purchase money security or floating liens. Philippines Chattel mortgages and pledges are permitted over movable property. Chattel mortgages must be recorded. Philippine law does not recognize chattel mortgages over future property; but courts have created exceptions for interests in inventories of raw materials, goods in process, and finished goods. Chattel mortgages may not secure future obligations. Thailand Only certain forms of movable property may be mortgaged, including large ships and boats, floating houses, beasts of burden, and classes of machinery. Creditors holding rights of retention are also recognized as secured creditors. Other types of property may be pledged. Enforcement of secured rights requires either a court judgment or a public auction and is slow and costly. Fixed and float- ing charges are not permitted at present but would be allowed under the secured transactions law that is now in draft. The enforcement of unsecured debt in Thailand can extend for many years. Malaysia, Hong Kong (China), The laws in all three jurisdictions provide for a variety of securities over movable property (both and Singapore tangible and intangible) including charges, liens, and pledges. Retention of title is also permitted. Security may be taken over future property. Fixed charges may be taken over tangible assets and floating charges over classes of variable assets such as inventory and/or book debts. Less clear is whether secured creditors may take fixed charges over book debts. These English-origin systems require the registration of many types of charges, including charges over book debts and floating charges over the general undertaking of a company, but statutory rules are less clear and com- prehensive than the U.S. Uniform Commercial Code Article 9. Usual practice in these three jurisdictions is for a debenture to provide a secured financial creditor, with the contractual reme- dies upon default allowing the appointment of a receiver or special manager. All three jurisdic- tions have efficient debt-collection procedures for non-secured creditors. Source: Arner and others 2006. 58 East Asian Finance registration or filing, since in most transactions the collateral, either through the judicial process or by debtor is unable to part with the collateral. Never- way of public auctions. theless, in some jurisdictions in the region, posses- An inefficient system of security enforcement sion is a frequently used financing mechanism. often leads to an ineffective corporate rescue mech- Registration also plays a central role in the order- anism because in those jurisdictions where it is diffi- ing of priorities. In some jurisdictions the registry cult for creditors to enforce their security interests, it (which is usually government-run) merely serves as a is difficult to pressure debtors to come to the table to filing office. However, in others, including China, negotiate with creditors and seek a collective remedy. Indonesia, and Thailand, the registration process is And ultimately the secured creditor might be forced much more complex because the government checks to exercise his rights in a liquidation proceeding. the information and in effect guarantees the legality Unfortunately, the enforcement mechanisms in of the underlying transaction. In such jurisdictions, use throughout much of the region take too long, the parties must also submit the originals or copies of are too expensive, and are commercially inefficient. their security agreement. This type of system is much Some of the strongest criticisms pertain to the en- slower and more expensive than a pure filing system. forcement of claims against real estate. In such cases, a need for judicial assistance is the norm and the Enforcement of secured rights process is slow. A further problem is that even where Efficient, inexpensive, transparent, and predictable a creditor's actions are uncontested, judicial assis- methods are needed for enforcing a security interest tance is still often required. In general, it is best to in property. Both judicial and non-judicial methods minimize the need for judicial assistance, and where of enforcement should be considered. Enforceabil- the need exists, it is important to expedite the process. ity is easiest when the law allows parties to agree on Table 3.7 gives a broad assessment of where coun- their own default remedies, bypassing courts, but tries in the region stand regarding the key elements provides adequate safeguards to the debtor where needed for unsecured and secured lending. court involvement would be required. Out-of-court mechanisms may include self-help remedies where Insolvency systems these can be exercised consensually without violating the legal rights of others. Where self-help remedies Experience suggests that, to be most effective, insol- are unavailable, enforcement procedures should en- vency systems should be integrated with a country's able the parties to obtain enforcement on summary, broader legal and commercial systems and should accelerated proceedings for the recovery and sale of be designed with regard to eight principles: (1) max- TABLE 3.7 Assessment of Unsecured and Secured Creditor Rights Secured rights Unsecured rights Security-interest Registration and disclosure Enforcement of Economy Enforcement legislation of secured rights secured rights China 2 2 2 2 Indonesia 1 2 1 1 Rep. of Korea 3 3 3 3 Malaysia 5 4 4 5 Philippines 2 2 2 2 Thailand 2 1 1 2 Hong Kong 5 4 4 5 (China) Singapore 5 4 4 5 Source: Arner and others 2006. Notes: Score 1 (lowest) to 5 (highest). The table highlights the ease and cost of creating reliable security interests, systems for such interests to be disclosed, the costs and risks associated with enforcing charges, the relationship of security and collateral with bankruptcy and receivership practices, and the operation of creditor protection and stays to enforcement. Building Better Institutional Infrastructure 59 imize the value of a firm's assets, including by pro- regimes and to supplement them with modern viding an option to reorganize; (2) strike a careful corporate-rescue procedures, including both formal balance between liquidation and reorganization; court-based regimes and out-of-court and adminis- (3) provide for equitable treatment for similarly trative procedures. Indonesia, Korea, Malaysia, the situated creditors; (4) prevent the premature dis- Philippines, and Thailand have reformed their insol- memberment of a debtor's assets by individual vency laws. The other economies--China, Singapore, creditors seeking quick judgments; (5) provide for and Hong Kong (China)--have had ongoing law re- timely, efficient, and impartial resolution of insol- forms, with those in Hong Kong (China) and China vencies; (6) provide a transparent procedure that dating from before 1997. contains incentives for gathering and dispensing Indonesia amended its 1998 Bankruptcy Ordi- information; (7) reorganize existing creditor rights nance by a government regulation in lieu of a law. and respect the priority of claims with a predictable Indonesia also established a commercial court after and established process; and (8) establish a frame- the crisis to hear bankruptcy cases, although there work for cross-border insolvencies, with recogni- have been perceptions of corruption and concerns tion of foreign proceedings. about inconsistent application of the Bankruptcy Table 3.8 provides a broad assessment of where Act in the past. Further amendments to the Indone- East Asian countries stand with respect to the key el- sian law were enacted in 2004. ements of insolvency regimes. Among the crisis-affected countries, Korea has Before the financial crisis, only Singapore had made the most significant changes to its formal in- an insolvency regime adequate to deal with a large solvency law. Many of the changes were intended to number of corporate failures. Other countries were expedite the reorganization procedures. Creditors' hampered by antiquated laws and procedures, many committees are now included in composition pro- of which dated from colonial times; all of them used ceedings and management committees are included liquidation-based procedures. For the most part, the in reorganizations, while the time limit for reorgani- insolvency laws were underused for liquidation zations has been halved from 20 to 10 years. Further and seldom used for corporate reorganization. In amendments were made in 2000 and 2001, including Indonesia and Thailand, insolvency laws provided formalizing an out-of-court Workout Accord in the for both liquidation and suspension of payments reorganization legislation to enable creditors to file procedures, but were rarely used. proceedings to bind foreign creditors. A recent major In the aftermath of the financial crisis, coun- change is the Debtors' Rehabilitation and Bankruptcy tries began to reform or replace archaic liquidation Act, which came into effect in April 2006. This new TABLE 3.8 Assessment of Insolvency Regimes Legal framework for Corporate insolvency Judicial decision making Effective insolvency Economy corporate insolvency implementation and enforcement practitioners China 1 1 1 1 Indonesia 2 1 1 1 Rep. of Korea 4 3 3 3 Malaysia 4 3 3 3 Philippines 2 2 2 2 Thailand 3 2 3 3 Hong Kong 4 5 5 5 (China) Singapore 4 5 5 5 Source: Arner and others 2006. Notes: Score 1 (lowest) to 5 (highest). The appraisals acknowledge extra-legal regulatory guidance for collaborative multi-creditor practice, for example, in Hong Kong (China), Indonesia, Malaysia, and Thailand. In these jurisdictions, regulators have attempted to instill informal corporate-reorganization practices similar to the well-known "London Rules," in some cases coming into conflict with the courts. In both Hong Kong (China) and Singapore, systems and prac- tice are well established and generally sophisticated, but legislative reform has tended to lag behind both market practice and the willingness of the courts to intervene creatively in cases of corporate distress. 60 East Asian Finance legislation consolidates Korea's three different in- tors to initiate a process of insolvency to get paid. solvency acts for the first time. There are other reasons, too, why secured creditors In the Philippines, the pre-1997 insolvency law should retain their level of priority in insolvency pro- dated from 1909; it included a rarely used liquidation ceedings. First, granting concessions to other groups procedure and a suspension-of-payments process not merely hurts the secured creditors' interests but for corporate rescue that was available only to sol- is likely to kill the secured-lending system. Second, a vent companies experiencing temporary cash-flow problem with allowing the claims of other groups problems. Any proposal for debt rearrangement re- (such as workers or tort claimants) to supersede the quired the full payment of debts and so was rarely rights of secured creditors is that there is no way for used. Amendments to the law were made in July a bank to quantify these possible claims at the time 2000. Among the most significant changes was that that it contemplates lending to the company. the jurisdiction for rehabilitation and suspension of Thus, ensuring an effective framework for securing payment cases was transferred to the courts. Other transactions is important. Some general principles reforms are under discussion, notably a Corporate are that where, before insolvency or in contempla- Recovery and Liquidation Act intended to further tion of insolvency, a company charges or mortgages improve the rehabilitation and liquidation regimes. an asset to a creditor in exchange for the credit pro- However, the congressional passage of these bills has viding value to the company: (1) such a charge or been slow. mortgage should not be voided by a subsequent in- In Thailand, a new chapter on business organi- solvency proceeding; (2) secured creditors should be zation was added to the Bankruptcy Act in 1998 to permitted to convert an unsecured debt into a se- facilitate corporate rescues. One of the reforms cured debt as long as such transactions are entered provided for the appointment of a bankruptcy plan- into a long time before an insolvency commences; ner to manage the affairs of the debtor company and (3) fraudulent or commercially unfair transactions prepare a plan of reorganization. Another impor- that have a security component should be avoided; tant reform was the establishment of the bankruptcy (4) post-petition grants of security should be per- court in 1999. mitted; (5) pre-petition interests should continue in The insolvency laws in Malaysia, Hong Kong post-petition proceeds; and (6) priorities in insol- (China), and Singapore share a basic structure of de- vency should be avoided. tailed liquidation procedures and an abbreviated Rather than inserting priorities into insolvency scheme-of-arrangement procedure for use in corpo- legislation that adversely affect the rights of secured rate rescues. The liquidation procedure in these laws creditors, countries should enact non-insolvency is the most efficient in the region (although in need remedies that would preserve the economic gains of modernization), but the scheme-of-arrangement from secured transactions, yet also enable these other procedure is cumbersome and expensive. The pro- groups to obtain payment of their claims. In general, cedures in Hong Kong (China) and Malaysia do not the global trend in insolvency laws is to abolish statu- provide for an automatic stay in the absence of a tory priorities in insolvency; for example, the govern- winding-up order; Singapore operates a stay only on ment should not have priority in insolvency for tax unsecured creditors. None of the jurisdictions in claims. The one area that receives general support for the region has a mechanism to force uncooperative retaining statutory priorities in insolvencies is that secured creditors to the bargaining table. involving the claims of employees and workers. All this said, the benefits of secured lending do not mean that the insolvency or reorganization law Interaction between creditor rights should always promote a policy of non-intervention. and insolvency Clearly, if insolvency or reorganization laws pose To what extent should the pre-existing rights of se- unreasonable threats to lenders, lenders will most cured creditors be adversely affected by insolvency? likely curtail lending or raise interest rates, or both. Secured lending produces important economic Thus although the law should generally respect the and social benefits--such as increasing the amount pre-existing priority rights of secured creditors, from of credit extended and reducing the need for credi- the standpoint of insolvency the aim must be to: Building Better Institutional Infrastructure 61 (1) define those circumstances when the collective or In Indonesia, national financial reporting stan- public interest justifies allowing insolvency to inter- dards (PSAK) are converging toward the International fere with the rights of secured creditors; (2) define Financial Reporting Standards, with full adoption the types of interference that should be permitted; planned in 2008, but at present there are some sig- and (3) propose mechanisms to protect the interests nificant differences. The PSAK have not yet adopted of secured creditors whose rights have been adversely the concepts of IFRS32 and 39, particularly in the affected by such interference. Creating clear, nar- measurement and recognition concepts of finan- rowly drawn rules as to when the insolvency law will cial statement instruments such as asset, liability, interfere with the rights of secured lenders is unlikely and equity. Efforts are underway to adopt IAS32 to pose an unreasonable threat to lenders. and 39 with regard to fixed assets; while the PSAK Overall, East Asian countries would benefit from refer to the historical cost concept, they do permit enacting insolvency laws that respect the pre-existing the recognition of asset revaluation with the gov- rights of secured creditors. However, in deciding to ernment's approval. what extent exceptions to the rule should be permit- China announced recently that the Chinese Ac- ted and how best to structure the balance between counting Standards (CAS) will converge with in- secured transactions and insolvency, governments ternational standards in 2007. The CAS currently must first determine which approach is most appro- comprise one basic and 16 specific standards, most priate for adoption in their jurisdiction. of which were issued between 1996 and 2001. The process of convergence will involve integrating Accounting Standards and Practices the IFRS principles into the CAS and will result in the amendment of all existing standards and the The quality of financial information available to share- issuance of an additional 22 specific standards. holders and creditors, and to stakeholders more While the revised CAS will not reflect a literal broadly, depends on both the quality of financial translation of the IFRS, their scope will include all reporting (accounting) standards and the strength IFRS principles. of enforcement mechanisms. As countries move toward convergence, full dis- closure of the existing differences is important. Standards East Asian countries are at different stages of conver- Practices gence toward international accounting and auditing standards. In Korea, for example, although the law Enforcing existing financial standards is also impor- does not require compliance with international tant. In most countries in the region, compliance standards, the Korean Financial Accounting Stan- with and enforcement of standards pose more of a dards (KFAS) are generally consistent with the In- challenge than the adoption of new standards. ternational Accounting Standards (IAS). The most There are three main links in the enforcement significant difference is that the KFAS do not require chain of financial reporting standards: those who consolidated financial statements as the primary fi- prepare financial statements; the auditors of fi- nancial statement. Additionally, special-purpose en- nancial statements; and the regulators. The exter- tities are often not consolidated. The KFAS do not nal audit provides shareholders, regulators, and allow revaluation of fixed assets, while the Interna- other stakeholders with a greater degree of assur- tional Financial Reporting Standards (IFRS) refer to ance that the financial statements of a company the fair-value concept, according to which the finan- are a true and fair representation of the company's cial statements should periodically be adjusted to financial position. Independent auditors must earn the fair value of assets. the confidence of the investing public by adhering The Philippines has adopted the International to high standards of professional conduct that pro- Accounting Standards and International Financial vide assurances as to the integrity and objectivity Reporting Standards without material changes,44 of their services. Without competent, indepen- and has also adopted transition provisions for each dent audit firms to support the application of ac- IAS and IFRS. counting standards, there is no assurance that 62 East Asian Finance those standards will be consistently and correctly Summary applied. Among the crisis-affected countries, Korea and To ensure high-quality financial reporting, man- Malaysia, followed by Thailand, have moved the agers of firms need the incentive to take the steps re- furthest in reforming their laws and regulations and quired to comply with the applicable accounting standards in preparing financial statements; audi- practices. Indonesia and the Philippines still have tors need to be able and willing to fulfill their pro- considerable scope to strengthen their corporate fessional obligations; and regulators need to have governance practices. China has recently begun to the legal authority and capacity to monitor financial strengthen its corporate governance. reporting and auditing practices and enforce applic- It is important to continue to raise the awareness able accounting and auditing standards. of good corporate governance principles and prac- Strong shareholder rights and practices that tices among companies, directors, shareholders, and provide the appropriate incentives for company other interested parties in the region. managers to comply with accounting standards can Broadly, the key challenges with respect to cor- provide an impetus to a country's adoption of good porate governance lie in ensuring the effective exer- accounting standards and practices. A recent empiri- cise of minority shareholder rights, in improving the cal study, based on data from 31 countries, found that quality of financial reporting and disclosure, and in high accounting standards and their enforcement in strengthening the rule of law. In many, if not most, high-quality auditing are more likely to exist in coun- cases, the legal and regulatory requirements on infor- tries with strong legal and institutional arrangements mation disclosure, shareholder and creditor rights, for investor protection, and that in such countries, and accounting and auditing standards, are in place. better accounting and auditing practices are posi- But implementation and enforcement are often weak, tively associated with financial market development because regulators lack sufficient independence, skills, (Francis, Khurana, and Pereira 2002). or resources. Fostering an 4 Efficient and Sound Banking Sector Banking remains the dom- Against the backdrop of the developments that have taken place in banking in the region since the financial crisis, this chapter inant financial segment in addresses several questions: the East Asian countries, with banking sector assets To what extent have banks resumed their role in intermediation? What is the appropriate policy environment to ensure the effi- accounting for almost cient provision of a wider range of services to a broader set of 60 percent of GDP on borrowers? average. Thus the perfor- In light of the new challenges that arise in meeting a broader set of demands and providing new services--and in the con- mance and issues pertain- text of the changing banking landscape globally--what key ing to the banking sector areas of banking regulation and supervision do countries need to strengthen? continue to be of para- Most countries in the region have announced their intention to mount importance to the adopt the Basel II Capital Adequacy Framework (Appendix 3). overall financial systems What is needed to ensure the effective implementation of Basel II in the region? in the region. With an appropriate regulatory Developments in East Asian Banking and policy environment, Since the Financial Crisis East Asian banks could This section first reviews changes in the structure, then develop- become more efficient and ments in the efficiency, reach, and soundness of the banking sector. serve a wider set of needs, Structure while strengthening their Significant structural changes have taken place in the banking soundness. sectors of the crisis-affected countries, in response to policy- makers' efforts to address issues of capitalization, governance, risk management, and operational inefficiencies in the aftermath of the crisis. These efforts have included closures and consolida- tion of banks, often entailing initial nationalization followed by re-privatization. Consolidation has also taken place in the banking sectors of Hong Kong (China) and Singapore, which were not directly af- fected by the crisis. Here, as in other advanced industrialized economies, the trend has been driven by competitive pressures arising from deregulation (domestic and foreign) and technolog- ical advances. 63 64 East Asian Finance TABLE 4.1 Changes in the Structure and Ownership of Commercial Banks Concentration Banking ratio of Average state Average foreign sector assets assets of top ownership in ownership in Number of banks (percent of GDP) three banks top ten banks top ten banks (1) (2) (percent) (3) (percent) (4) (percent) (4) Economy 1997 2002 2004 1997 2004 1997 2004 1997­99 2004 1997­99 2004 China 86 129 135 107 162 73.2 61.0 96.4 89.7 0.02 3.2 Indonesia 222 142 134 85 62 n.a. 42.2 73.8 51.3 0.0 16.7 Malaysia 36 26 25 170 169 22.8 33.1 10.9 3.5 15.9 26.2 Rep. of Korea 16 11 8 98 106 50.7 50.6 37.2 5.8 12.2 21.3 Philippinesa 51 24 24 104 70 29.6 29.4 7.8 5.8 11.3 9.0 Thailand 16 13 12 156 113 47.4 47.8 1.3 29.3 8.1 11.7 Hong Kong 361 224 208 587 485 29.7 53.4 0.0 0.3 63.1 66.5 (China)b Singapore 152 120 113 204 221 75.6 91.8 0.0 4.0 8.3 15.6 Japanc 148 137 129 151 148 26.9 35.3 0.0 1.3 0.2 3.6 Germanyd 326 273 252 152 188 15.3 44.2 1.7 2.7 3.5 5.8 United 452 385 380 302 403 23.4 31.1 0.0 0.0 2.9 12.8 Kingdom United States 9,060 7,798 7,532 58 69 17.3 30.3 0.0 0.0 0.0 3.2 Sources: (1) Country sources and European Banking Federation; (2) country sources; (3) Bankscope and country sources; (4) based on shareholders disclosed in Bankscope and Bankers' Almanac. a. Figures are for 1999 instead of 1997. b. Registered financial institutions. c. Domestic licensed banks. d. All banks excluding credit cooperatives, mortgage banks, building associations, and special banks. In all jurisdictions in the region except China, the try's top ten banks amounted to 51 percent in 2004. number of banks has declined significantly, as the Foreign ownership however, is higher than before result of consolidation (Table 4.1). In most, the ex- the crisis, having risen from about 9 percent of total tent of state ownership has also declined, while for- banking sector assets in 1997 to 31 percent in 2004. eign ownership and participation have increased. The In the Republic of Korea's first round of consoli- pattern varies quite widely across countries, however, dation, five banks with capital-adequacy ratios below and state ownership remains relatively high in In- the 8 percent guideline recommended by the Bank for donesia and Thailand as well as China. International Settlements were taken over by healthy In Indonesia, the number of commercial banks banks. Seven banks merged to form three successor declined from 238 in 1997 to 134 at the end of 2004 banks in 1999, and another two merged to form one (72 private national banks, 5 state owned banks, successor bank in 2002. However, most of the banks 31 foreign and joint venture banks, and 26 regional that received public funds and were assessed as viable development banks). The privatization of the In- in the initial stage of restructuring were unable to turn donesian Bank Restructuring Agency returned more themselves around. The second round of consol- than 20 percent of the banking sector's assets to the idation, dating from the beginning of 2001, has private sector. State ownership of banks has de- focused on reinforcing the competitiveness of do- clined from its 1997­9 level, but the state retains a mestic banks. To that end, it has emphasized three large share at 44 percent. If this is combined with the approaches: (1) positioning troubled banks under 6 percent share of regional development banks--the government-led financial holding companies; fastest-growing component of the banking sector-- (2) merging provincial banks with national banks; and more than half of the assets of banks in Indonesia (3) promoting consolidation among sound banks. are under state ownership. This proportion is higher The number of commercial banks has been halved, than before the crisis. State ownership in the coun- from 16 in 1997 to 8 at the end of 2004. Korea's re- Fostering an Efficient and Sound Banking Sector 65 privatization efforts have resulted in a much larger government recapitalized three of the four state- share of both private ownership and foreign owner- owned banks to the tune of US$75 billion46 and ship than before the crisis. Thus in the top ten banks, transferred their nonperforming loans to asset private ownership increased from 62 percent during management companies, in preparation for public 1997­99 to 94 percent at end-2004. Average foreign offerings. In fact, the China Construction Bank has ownership--which was quite low at 12 percent before recently completed a high-profile public offering on the crisis--also increased, to reach 21 percent in 2004. the Hong Kong Stock Exchange. The Industrial and Malaysia's first stage of consolidation reduced Commercial Bank of China and the Bank of China, the number of banking entities from 55 (comprising which have received approval for their selection of commercial banks, finance companies, and mer- international strategic investors, are preparing for chant banks) to ten groups comprising 31 entities. initial public offerings in 2006. The total equity share In the second phase of consolidation, mergers have acquired by foreign institutions amounts to 20 per- been taking place between banks and their finance cent in the Bank of China, 14 percent in the China company subsidiaries and among the country's ten Construction Bank, and 10 percent in the Industrial remaining banking groups. As a result, the number and Commercial Bank of China. of commercial banks declined from 36 in 1997 to 25 Most countries in the region have eased their at end-2004. Changes in ownership have also oc- restrictions to allow banks to conduct business in curred: between 1997­99 and 2004, average state areas such as securities and insurance. Banks are re- ownership in the top ten banks declined from 11 per- sponding, to varying degrees, by offering fee-based cent to 3.5 percent, while average foreign ownership services in new areas, and some are beginning to increased from 16 percent to 26 percent. form strategic alliances with other financial institu- The Philippines, too, has seen consolidation in its tions and to outsource their non-core operational banking sector, with the number of commercial banks functions with a view to achieving greater opera- falling from 51 in 1997 to 24 in 2004. Including uni- tional efficiency. For example, four foreign banks versal banks--that is, large banks that do both com- have set up regional processing centers in Malaysia. mercial and investment banking--commercial banks number 44, down from 52. The bulk of the banking Efficiency and health system is privately owned but foreign ownership remains very small (averaging 9 percent in the top Measured by standard indicators such as the ratio of ten banks). operating costs to assets, banks in the region have In Thailand, the greatest consolidation activity increased their efficiency since the period immedi- has taken place among smaller finance companies, ately after the crisis. Indeed, countries in the region reflecting the closure of 56 defunct finance compa- now compare favorably to countries in other regions nies. As a result of mergers among banks, there are in terms of such indicators (Figure 4.1). now 12 commercial banks, down from 16 in 1997.45 Indicators of bank soundness also show a signif- Thailand's banking system is the only one where state icant improvement from the trough reached imme- ownership in the top ten banks--averaging 29 per- diately after the crisis (Figure 4.2). cent at end-2004--is sizably higher than immediately In Indonesia, where the nonperforming loan after the crisis. While average foreign ownership in (NPL) ratio of banks peaked at 48 percent in 1998, the top ten banks has increased, it remains relatively the recovery in the asset quality of commercial banks limited, at below 12 percent at end-2004. has been quite impressive. As of end-2005, their NPL Structural changes have also taken place in coun- ratio stood at 7.6 percent.47 As in several of the other tries not directly affected by the financial crisis. In crisis-affected countries, much of the initial decline China the number of commercial banks has in- in the ratio reflected the transfer of assets to asset- creased. Average state ownership in China's top ten management companies--in this case the Indonesian banks has declined somewhat, falling from 96 per- Bank Restructuring Agency, in exchange for govern- cent in 1997­99 to just less than 90 percent at end- ment recap bonds. From 2001 onward, however, the 2004, while the average foreign ownership rose from NPL ratio was improved through a combination of 0.02 percent to 3 percent during the same period. write-offs, debt restructuring, and recoveries. Most Further changes took place during 2005, when the recently, the improvement in the ratio has reflected 66 East Asian Finance FIGURE 4.1 Indicators of Banking Sector Efficiency a. Operating costs to total assets b. Operating costs to total assets, 2004 5 7 1998 6 4 2001 5 2004 nt 3 4 rce pe 2 3 2 1 1 0 0 ina sia rea s re ina s sia sia nd n ileeecexicoPeTurkeyraine ru Ch laysia Ko ailand , China Ch lay f Ko pa anydomtates ChGr rm ing d S Me Uk Indone Ma p. of ilippine Th rea ineaila, Chinaapore JaGe Ph Singapo IndoneMap. o PhilippThKong Sing ite Re ng Kong Re ited KUn Un Ho Hong Source: Bankscope. FIGURE 4.2 Indicators of Banking System Soundness a. NPLs of the banking system b. NPLs of the banking system Indonesia China Rep. of Korea 1998 1998 Malaysia 2002 Hong Kong, 2002 June 2005 Philippines China 2004 Thailand Singapore 0 10 20 30 40 50 60 0 10 20 30 40 50 60 % of total loans % of total loans c. Profitability of the banking system d. Profitability of the banking system % 5 5 0 4 China asset, Hong Kong, China Singapore on ­5 3 ­10 Indonesia Philippines 2 return ­15 Rep. of Korea Thailand 1 of Malaysia te ­20 0 ra 1997 1998 1999 2000 2001 2002 2003 2004 2005 2000 2001 2002 2003 2004 2005 e. Capital adequacy ratios of the banking system f. Capital adequacy ratios of the banking system % 25 22 20 20 18 asset, 15 10 16 on 5 14 12 0 China 10 Hong Kong, China return ­5 Indonesia Philippines 8 ­10 Rep. of Korea Thailand Singapore of 6 ­15 Malaysia 4 te ra­20 2 1997 1998 1999 2000 2001 2002 2003 2004 2005 2000 2001 2002 2003 2004 2005 Sources: Country sources. Fostering an Efficient and Sound Banking Sector 67 loan growth, particularly to consumers and small tial decline in NPLs (during 1998 and 1999) re- and medium-size enterprises. Despite these improve- flected the sale of NPLs to the asset-management ments, however, the level of special-mention loans company Danaharta. Loan restructurings led to a and restructured loans in the Indonesian system re- further decline in NPLs in 2000, but the NPL ratio mains relatively high. rose again in 2001 as some of these restructurings The profitability of Indonesia's banks, as mea- came undone and as banks began to report some sured by the rate of return on assets, has also im- previously unreported NPLs. In subsequent years, proved since the crisis. The average rate of return on write-offs and further restructurings--made on a assets is estimated at 2.6 percent at end-2005--up more sustainable basis as a result of asset-sale pro- from negative 18 percent in 1998. Much of this im- grams and reductions in principal--reduced the provement in profitability occurred during 2002­04; NPL ratio. More recently, a slowdown in new NPLs, it reflected both a widening of net interest margins better loan recovery, and growth in the loan base and an increase in non-interest income from bond have further reduced the NPL ratio, and as of mid- sales and mark-to-market gains. There is an indi- 2005 the average NPL ratio of Malaysian commer- cation that the interest margins are now beginning cial banks stood at 12 percent. Profitability, as to narrow, because increased competition among measured by the rate of return on assets, has re- banks is spurring them to raise their deposit rates mained at around the 1998 level, but Malaysian while interest rates on lending have generally lagged banks are well capitalized, with an average capital- behind. The capital base of Indonesian banks remains adequacy ratio of around 13 percent at end-2005. strong, with the average capital-adequacy ratios at The strengthening of the banking sector has 19.3 percent at end-2005. This figure reflects the been slower in the Philippines. The NPL ratio stood retention of strong earnings during 2002­04, but at 8.5 percent at end-2005, which compares with also the still-substantial holdings of government 10.4 percent in 1998 but is a substantial improve- zero-weighted recap bonds relative to the loan base. ment from the double digits seen in the past few In Korea, the nonperforming loan ratio of banks years. The profitability of banks, while slightly higher is now the lowest in the crisis-affected countries, than immediately after the crisis, remains relatively standing at 1.2 percent at end-2005. Although a weak. However, the reported capital position of downward trend in the ratio was interrupted in banks is relatively strong, with an average capital- 2003--as a result of high credit-card delinquencies adequacy ratio of more than 18 percent at end-2005. following Korea's very rapid expansion of credit- In Thailand, the NPL ratio peaked at 45 percent card lending in 2001­02--banks have now largely in 1998 and has since come down significantly, to recovered. Initially after the 1997 crisis, banks in 8.3 percent in 2005, entering the single-digit range Korea transferred a sizable proportion of their non- for the first time since before the crisis. The NPL performing loans to the centralized asset manage- ratio of private banks is now sizably higher than that ment company, KAMCO, at fairly large discounts. of state banks, which were the main beneficiaries of In more recent years, they have sought to sell their government assistance and the Thailand Asset Man- NPLs to specialist asset-management companies, agement Company. Though some restructured loans notably from the United States. The profitability are still regressing to nonperforming status, reflect- of Korean banks has improved in the past four years ing limitations in debt reduction during the original but remains relatively low, with the rate of return restructuring process, the rate of regression has on assets estimated at around 0.7 percent in June slowed significantly since 2000, helped by the eco- 2005. In part this reflects the growing competitive nomic recovery. Restructured loans and impaired pressures on interest margins and on the volume of loans still account for a sizable part of Thai banks' lending, but also the state of the overall economy total loans (about one quarter at end-2004), leaving and the still-muted consumer confidence. Nonethe- the loan portfolio significantly vulnerable to po- less, the capital-adequacy ratio of banks is around tential adverse economic conditions. However, the 13 percent (end-2005). banking sector has become significantly more prof- Malaysia's banks have seen a steady improve- itable since 2003, due to the strong growth that has ment in asset quality and a progressive drop in their occurred in lending, in response to improving con- NPL ratios since the crisis.48 A large part of the ini- ditions in the economy overall and wider interest 68 East Asian Finance margins. Lending to corporate bodies remains weak, would have been set aside as additional loan-loss reflecting muted loan demand but also the banks' provisions under stricter rules. Also, while collateral aversion to risk; rather as in Korea and Malaysia, is often deductible from loan-loss provisions, this banks in Thailand are turning more to households practice assumes that if the borrower defaults the than to firms for new lending opportunities. Their im- bank can collect the assumed value of the collateral. proved profitability has enabled banks to strengthen How much the bank can actually collect will depend their capital base and the average capital-adequacy on the nature of the collateral and how the collateral ratio at end-2005 stood at more than 13 percent. is valued, and also on the country's bankruptcy code Elsewhere in the region, the health of the bank- and judicial system. Similarly, Basel rules permit reg- ing sector has also improved over the past few years. ulators to allow banks to deduct up to 45 percent of In China, the reported NPLs of commercial banks unrealized gains as Tier 2 capital. The proportion had fallen to 8.6 percent of total loans at end-2005 of their unrealized losses that banks are allowed to from 13.2 percent at end-2004, mainly as a result of deduct from capital can vary across countries.51 public recapitalization of the largest state-owned Second, the NPL ratio in East Asia remains high commercial banks.49 relative to those in other regions of the world, while While the overall improvement in the health of profitability and risk-weighted capital-adequacy ra- the banking sector in the region has been impres- tios remain slightly lower. sive, three points should be noted. Third, there is considerable variation in the NPL First, international differences in accounting and ratio across countries and banks in the region financial reporting standards and practices mean (Figure 4.3). that the standard financial ratios may overstate the performance and soundness of banks in some coun- Financial intermediation by banks tries. For example, although countries in the region have converged to the 90-day standard for overdue What are the trends in bank financial intermediation? payments to be classified as nonperforming, ambi- Do the relatively strong capital-adequacy ratios reflect guity can arise as to whether or not these standards the still-large holdings of government bonds with low apply to loans made on concessional terms (loans risk weights? Are banks lending to corporate entities that have been restructured via extended maturities again? To what extent have they broadened their lend- or reduced interest rates).50 The definition of con- ing to serve consumers? And have the structural cessional terms can also vary. Since provisioning changes that have taken place in the banking sectors rules require different percentages of provision for across the region--namely consolidation and changes different classes of loan, more lenient accounting in ownership--been accompanied by the provision of rules will overstate real capital by the amount that a wider range of services--both fee and non-fee FIGURE 4.3 Performance of East Asian Banks Relative to Those of Other Regions a. Performance of the banking sector b. Median NPL ratios and variance across across regions banks in the East Asian region 20 30 Emerging Asia 18 Europe worst 5% 16 25 Latin America 14 tne 20 12 rcep 10 15 median 8 median median 6 10 4 best 5% 5 2 0 0 nonperforming return capital adequacy 2002 2003 2004 loan ratio on assets ratio Source: IMF 2005. Fostering an Efficient and Sound Banking Sector 69 based? If so, how well are banks that are undertaking 1 percent per year in the Philippines. In Indonesia a broader range of such services performing? and the Philippines, holdings of government assets in Banks have yet to resume their pre-crisis role in banks still constitute around 15 percent of GDP. financing the private sector (Figure 4.4). In partic- ular, in Indonesia, the Philippines, and Thailand, Lending to consumers domestic credit to the private sector as a percentage Of the domestic credit that banks have extended of GDP is still sizably below pre-crisis levels. During to private borrowers, a growing share has gone to 1998­2004, domestic credit to the private sector as consumers (Box 4.1). In 2004, consumer lending a share of GDP declined in Thailand (its growth has accounted for 53 percent of total bank lending only turned positive since 2002) and grew by less than in Malaysia, 49 percent in Korea, 30 percent in FIGURE 4.4 Deposit-Money Banks' Claims on the Private Sector and Government a. Indonesia b. Rep. of Korea 70 100 DCP Government DCP Government 60 80 50 60 40 GDP of 30 40 % 20 20 10 0 0 1996 2000 2004 1996 2000 2004 c. Malaysia d. Philippines 140 70 DCP Government DCP Government 120 60 100 50 80 40 GDP of 60 30 % 40 20 20 10 0 0 1996 2000 2004 1996 2000 2004 e. Thailand f. China 120 180 DCP Government DCP Government 160 100 140 80 120 GDP 100 of 60 80 % 40 60 40 20 20 0 0 1996 2000 2004 1996 2000 2004 Source: IMF IFS. Note: DCP = domestic credit to the private sector. 70 East Asian Finance BOX 4.1 Reasons for the Expansion in Consumer Lending Lending to consumers has expanded significantly in most countries in the region over the past five years or so, although the ratio of household debt to GDP remains low in comparison to that of advanced industrialized countries. Household debt and per capita income 30 70 25 60 50 20 40 GDP thousands 15 30 of % US$ 10 20 5 10 0 0 ysia China Korea China apore . of Indonesia Mala Thailand Philippines Sing Rep Kong, Hong per capita income (left axis) household debt (right axis) What have been the main factors underlying this expansion in consumer borrowing? On the demand side, theory sug- gests that aggregate household demand for borrowing will depend on three main factors: demographics, expectations of future income, and expectations regarding the path of real interest rates. In particular, household indebtedness tends to rise when people expect incomes to grow, because households borrow against their expectations of higher future income in order to achieve a more stable path of consumption. The impact of real interest rates is theoretically ambiguous and de- pends on the distribution within the population of households at different stages of the life cycle. On the one hand, a de- cline in real interest rates decreases the costs of borrowing and increases the present value of labor income, encouraging households to borrow. On the other hand, lower real interest rates reduce the return on household assets, thus reducing the present value of their earnings and lowering the desired debt holding. The overall effect of a decline in interest rates will therefore depend in part on the demographics; younger households with prospects of higher income are more likely to respond by borrowing more, whereas older households with accumulated wealth are less likely to do so. On the supply side, the regulatory and institutional features--particularly those that limit the ability of households to borrow to their desired level and limit the timing of their borrowing--will determine the level of indebtedness. With the reduction in corporate-sector demand for bank financing over the past few years (as corporations have sought to restructure and have begun to find alternative sources of financing), banks and other financial institutions have in- creasingly focused their lending on the household sector and credit constraints on households have been eased. Brisk growth has occurred in consumer-finance products, ranging from vehicle hire purchase to credit cards. In several cases (such as in Korea) the supply of credit to households has also received an impetus from government policies. Consumer loans now account for more than 15 percent of total loans in Indonesia, Korea, Malaysia, and Thailand. Factors Affecting Growth in Consumer Loans Factors affecting household Factors helping to increase Economy borrowing demand availability of finance to households Indonesia Annual GDP growth of 4.6 percent in 2000­04. Increased focus of banks on retail lending, partly because corporations were bur- Real interest (lending) rate decline of more dened with debt overhang and needed to than 6 percentage points during 2000­04. deleverage. Fostering an Efficient and Sound Banking Sector 71 BOX 4.1 Reasons for the Expansion in Consumer Lending (Continued) Factors affecting household Factors helping to increase Economy borrowing demand availability of finance to households Malaysia Annual GDP growth of 5.3 percent in Increased focus of banks on retail lending, in 2000­04. part because corporates were burdened with Real interest (lending) rate decline of almost debt overhang and needed to deleverage. 1.5 percentage points during 2000­04. Rep. of Korea Annual GDP growth of 5.4 percent in 2000­04. Increased focus of banks on retail lending, in Real interest (lending) rate decline of almost part because corporates were burdened with 4 percentage points in 2000­04. debt overhang and needed to deleverage. Introduction of deduction from taxable In May 99: impetus to credit-card industry income equivalent to 20 percent of credit- through removal of cash advances, which card purchases in excess of 10 percent of had previously accounted for about half of gross income. Lottery ticket granted for total turnover. each purchase to increase credit-card usage and bring merchants into the value- added tax net. Thailand Annual GDP growth of 5.1 percent in 2000­04. Increased focus of banks on retail lending, Real interest (lending) rate decline of 3.5 per- in part because corporations were bur- centage points during 2000­04. dened with debt overhang and needed Tax breaks for homebuyers and tax incentives to deleverage. associated with sale and transfer of property. Government encouragement of government banks and state financial institutions to extend credit to constrained borrowers. Delinquencies in consumer lending vary among countries: In Indonesia, delinquencies on consumer loans have been fairly low, despite the rapid growth in lending. In Korea, since the economy stabilized after the crisis, losses have been extremely small on mortgage lending, but higher on unsecured consumer lending, including on credit cards. The latter were especially high in 2002 and 2003, when charge-offs peaked at close to 30 percent. Delinquency rates have since fallen to modest levels. Korea's Financial Supervisory Services (FSS) has historically set minimum provisioning charges for banks and credit-card companies. From 2006, FSS plans to replace its minimum provisioning requirements with a model-based system using historical loss data. The Korean government strictly regulates the loan-to-value (LTV) ratio on mortgage loans (to about 57 percent). In Malaysia, the nonperforming loan ratio for consumer loans is around 7.5 percent (down from 10.1 percent at end-2001). Most of Malaysia's nonperforming consumer loans are for housing, where the NPL ratio is 9.2 percent; the ratios for other types of consumer loan are much lower (at 3.7 percent for car loans, 4.4 percent for credit cards, and 2.2 percent for personal loans). In the Philippines, the recent growth in retail lending has been accompanied by high delinquency rates especially on unsecured lending, where the NPL ratio is almost 20 percent. Concerned about the lack of familiarity with consumer credit, and the relatively lax credit culture, the Philippine authorities have tightened the rules on credit-card lending. In Thailand, commercial banks' NPLs for housing have declined to 12 percent from a post-crisis peak of 30 percent, while those on vehicle hire purchase and credit cards have fallen to 5 percent (from 20 percent and 40 percent in the post-crisis peaks respectively). Sub-prime delinquencies are higher. Sources: World Bank, Fitch Ratings 2006. Indonesia, 17 percent in Thailand, 15 percent in In most countries, the bulk of lending to con- China, and 10 percent in the Philippines. In Hong sumers is mortgage finance--more than 77 percent Kong (China) and Singapore, consumer lending is in China, and more than half in Korea, Malaysia, and well developed and accounts for 40­50 percent of Thailand. In Indonesia, housing accounts for only total bank lending. However, loan growth over the 20 percent, while loans for motor vehicles account past few years has been quite sluggish in these two for 45 percent of loans to individuals. Loans for vehi- economies, reflecting weak property markets and cles are the next largest category after housing in most slower economic growth. countries. Credit-card lending has grown rapidly but 72 East Asian Finance typically remains quite a small proportion of con- ness and accessibility for lower-income groups. This sumer lending (for example, 10 percent in Indonesia section focuses on the mortgage markets in China, and 5.5 percent in Malaysia), except in Korea, where Indonesia, and Thailand. Although the discussion it accounts for about 30 percent.52 centers on the residential mortgage market, a thor- Despite the recent fairly rapid growth in consumer ough analysis of this market requires looking at the lending, household indebtedness remains low in East interplay between the mortgage markets, the hous- Asia in comparison to that in most advanced in- ing markets, and the bond markets. dustrialized countries, at around 61 percent of GDP In Indonesia and Thailand, the level of mortgage in Malaysia, 60 percent in Korea, and much less in debt has regained its pre-crisis levels at around 1.8 per- the other countries (34 percent of GDP in Thailand, cent of GDP and 15 percent of GDP respectively (fig- 13 percent in China, 8 percent in Indonesia, and 4 per- ure 4.5). In China, the pace of expansion of mortgage cent in the Philippines). debt has been impressive (figure 4.6). Underlying the growth in mortgage finance on Residential mortgage lending the demand side has been the rapid urbanization Residential mortgage markets in the region have re- that is taking place (with the urban population in vived and expanded since the crisis which had de- the region growing by 2.6 percent per year as com- pressed the national housing systems and was itself pared to a world wide average of 2.0 percent), and amplified by a real estate crisis in several countries, continued demographic changes. These factors will such as Indonesia and Thailand.53 continue to fuel demand for housing over the next Even excluding Hong Kong (China) and Singa- 5­10 years. In China, for example, it is estimated pore, countries in the region compare well to other that the urban population will increase from around regions in terms of the size of mortgage finance. 41 percent in 2005 to around 54 percent by 2020-- However, the markets are heterogeneous across the (including a rapid increase in the number of lower- countries in terms of scale, structure, depth, risk ex- middle-income households). The urbanization pres- posure, and accessibility. The evolution in market sure is also intense in countries such as Indonesia developments is raising new opportunities but also and Thailand, where the percentage of the urban challenges for national policy makers and regulators, population is currently still relatively low (48 per- both from the perspective of financial sector sound- cent and 32 percent, respectively) and is increasing. FIGURE 4.5 Size of Mortgage Debt Size of mortgage debt, early 2005 60 mortgage debt to GDP mortgage debt to all loans 50 40 30 percent 20 10 0 China Indonesia Rep. of Korea Malaysia Thailand Hong Kong, China Fostering an Efficient and Sound Banking Sector 73 FIGURE 4.6 Residential Mortgage Markets in China Evolution of residential mortgage markets in China 10 8 GDP of 6 percent 4 2 0 1997 1998 1999 2000 2001 2002 2003 2004 In China the demand for housing has also been fu- that mortgage lending in China remains a new activ- eled to some extent by a lack of alternative invest- ity for most banks, which compete through volumes ment opportunities (insurance products, capital without adjusting their underwriting and servicing markets) to channel household savings.54 policies to costs and risks. Although the Peoples' Bank There have also been factors operating on the of China (PBOC) has liberalized mortgage markets in supply side, including some improvements in mort- 2005, banks are still not pricing these loans accord- gage infrastructure that have facilitated the expan- ing to risks as they are still competing by applying sion of mortgage lending from the perspective of the floor level set by the PBOC (5.51 percent); the creditors. For instance, as mentioned below, a new pilot fixed rate mortgages introduced do not reflect credit bureau, which includes retail loans, has just any premium in line with the additional market risk. been established in Thailand. Indeed, since the cri- Measures to enhance risk management in banks are sis, most lenders have improved their organization, therefore much needed. In the meantime, it would mortgage lending underwriting, servicing stan- be important for the regulatory authorities to en- dards, and IT systems, and have introduced new force strict lending safeguards, notably through high scoring tools. loan to value limits (at 70 percent these are even As noted in box 4.1, bank lending since the crisis higher than those imposed in Korea). Also impor- has been largely directed toward the consumer seg- tant to note is that there is potential vulnerability ment, and much of this lending has been for mort- and concentration exposure from other property- gage finance. In fact, banks are, at present, the main related loans (to developers and commercial prop- providers of mortgage finance in the region.55 Thus erties) in some countries in the region. In China, for the aftermath of the crisis has favored the rise of pri- example, the nonperforming loan (NPL) ratio of vate mortgage markets over specialized public lenders, banking loans to developers reached a record 10.5 per- as seen in Korea and Indonesia. The housing banks cent at the end of 2004. in the region (mostly in Indonesia and Thailand) While there has been a steady expansion in mort- now operate as commercial banks and are supervised gage finance over the past few years, there are aspects as such. They both lend to the unsubsidized middle- of the key building blocks of mortgage finance that income household markets as well as lower-income could be strengthened in several countries in the re- households (with subsidies from the government).56 gion, but most notably in China. Well-functioning So far, the quality of the residential mortgage port- primary mortgage markets require certain elements folio has been excellent, despite the rapid pace of be in place, including (a) the legal foundations for growth in lending.57 It is important to note, however, an efficient system of collateral; (b) good property 74 East Asian Finance valuation mechanisms; (c) availability of consumer The Thai Valuers Association. In Indonesia, the ap- information (credit scoring methods and credit in- praisal profession is regulated by two professional formation); and (d) mortgage default insurance.58 organizations who qualify their members. Many These elements are in place to varying degrees across banks have in-house appraisers, but in the case of countries in the region. large complex properties, they hire outside appraisal The legal foundation of an efficient system of col- firms for second or third opinions. However, a 2001 lateral has several key dimensions, including clear title study by the Housing Market Indonesia (HOMI) and ownership rights; an up-to-date, reliable, and project found the methods used by the appraisal transparent property registration and cadastre sys- profession still lacking: too often the value of prop- tem; efficient foreclosure procedures and the ability erties is based on "costs" or developer's sale prices to evict the defaulting debtor after foreclosure; and an rather than on real (resale) value. appropriate priority ranking for the mortgage lien for Consumer credit bureaus and credit scoring can payment disbursement from foreclosure proceeds. As significantly increase the credit extended by financial noted in Chapter 3, countries are at different stages institutions (see box 4.7). In Thailand a new credit regarding the legal foundations for mortgage lending. bureau that includes retail loans has been established, In China, the enforceability of foreclosure remains and a project to create a Real Estate Information Cen- largely untested. In Indonesia, while security interests ter is ongoing. Indonesia has also recently established can be taken over land and mortgage lending is a private credit bureau, and except for China, coun- adequately regulated in the law, it can prove more dif- tries in the region now have credit bureaus in place, ficult for creditors to enforce a security interest. The although, as shown in table 3.3, the characteristics of main weakness in the law is that in cases where the oc- the credit information infrastructure vary consider- cupant of a foreclosed property refuses to vacate the ably across countries in the region. premises, eviction requires a court order. Thus en- Finally, mortgage default insurance--a special- forcement can take several years. In Thailand, there is ized form of credit insurance that protects both res- a need to develop national standards for property title idential mortgage lenders and investors in mortgage securities against potential losses caused by a bor- and mortgage registration for all regions as well as rower's default--if well designed, can significantly electronic data systems for title and registration in- reduce non-price credit rationing and the require- formation. And, although the process has improved ment for a large down payment (see, for instance, since the crisis--partly as a result of internal improve- the positive experience of the Hong Kong Mortgage ments by the courts and partly due to the greater ex- Corporation Box 4.2).59 At present there is no mort- perience gathered in having gone through the crisis­, gage insurance in Thailand, Indonesia, or China. foreclosure can still take a long time, and as long as However, new initiatives are under way to introduce 5 years if resolved through the courts. national systems of mortgage default insurance in Property valuation systems, both for the value of Thailand when a project is already fairly advanced, the loan at origination and for changes in value over and in China. Such developments would require the life of the loan, is a second component of an ef- modifications to the regulatory framework of the in- ficient collateral system. The quality and reliability surance sector and additional efforts to develop ap- of property valuation standards were brought into propriate standards to avoid problems of adverse question in some countries during the crisis, notably selection and moral hazard. in Thailand and Indonesia. Since then significant ef- Continued efforts to strengthen these key build- forts have been made to upgrade appraisal standards ing blocks will be important in ensuring that the and to enforce already existing codes of ethics. In growing demand for mortgage finance can be met Thailand valuations for public purposes must be efficiently going forward. carried out by listed key valuers approved by the Most markets offer attractive conditions for their SEC. The Bank of Thailand (BOT) also recently is- mortgage loans, with adjustable credit rates between sued notifications requiring that collateral appraisals 5 and 8 percent per year.60 The maturities of the loans conform, at a minimum, to the generally accepted may be 20 to 25 years (or even up to 30 years in Thai- appraisal standards and codes of conduct like those land and China), although the actual average life of used by the Valuers Association of Thailand and housing loans is between 10 and 15 years (and much Fostering an Efficient and Sound Banking Sector 75 BOX 4.2 The Hong Kong Mortgage Corporation The Hong Kong Mortgage Corporation (HKMC) was established in 1997 as a specialized and public owned secondary mortgage company. Its objectives are similar to other such companies created in the region: (a) to provide liquidity and risk management tools for the competing mortgage lenders and (b) to develop corporate bond markets and securitiza- tion. Its sole shareholder is the Hong Kong Exchange Fund (with an authorized capital of HK$ 3 billion). The Company was created when banks were operating in an environment of a liquidity crunch; however, at present, these banks are very liquid and well capitalized and have limited interest in securitizing their best performing mortgage loans. (The res- idential mortgage portfolio has demonstrated excellent resiliency even during adverse times, and the non-performing loan ratio has now reached a historical low of 0.53 percent.) The HKMC has been funding its mortgage purchases by issuing bonds (it has a large debt issuance program but also issues MBS pass-throughs). (However, as noted above, given the liquid conditions that they are operating under, banks have been reluctant to sell their mortgage portfolios, which has limited the net funding contribution of the HKMC to mort- gage markets--HKMC owns about 5 percent of the overall portfolio, mostly funded by simple bonds, as opposed to MBS). Since 1999 HKMC has also been gradually extending a successful mortgage default insurance program for lenders, which sells a limited first loss guarantee for mortgage loans exceeding the regulatory limit of 70 percent loans to value (LTV). The program can increase the LTV ceilings to up to 95 percent. The insurance program is partly reinsured by the private sector. The existence of this program has improved the affordability of housing finance for households that would not have the ability to make sufficient down payments for their loans. The penetration ratio of this insurance program rose to 25 percent by end-2005 (for a total of 35,000 households). less in Korea where the market is mostly made up of tive of policymakers in the region, and is currently 3­5 year bullet interest-only loans that would be being pursued in several countries through public better labeled as homeowner loans61,62). However, sector­specialized financial institutions. product variety remains limited in most of the East If banks are to offer long-term fixed rate mort- Asian countries. In particular, uncapped adjustable gage loans however, their funding structure should rate loans are the dominant product. Such loans are also be diversified from their dependence on short- attractive during a phase of declining short-term mar- term deposits to longer term mortgage- backed secu- ket rates, which has been the case in the recent past, rities, which would enable banks to transfer part of but entail a larger potential credit risk in the long run the interest rate risks to institutional investors. should any adverse economic shocks result in rising The key legal and regulatory elements needed for market rates.63 Indeed, since the end of 2005, mort- securitization, including mortgage backed securi- gage rates have increased by an average of 1.0 percent ties, are discussed in chapter 7. In addition, the de- to 1.5 percent, which has been passed on to consumers velopment of a secondary mortgage market requires through these adjustable rate loans (see table 4.2). sizable, standardized, and seasoned primary mar- Further significant increases in mortgage rates could kets with reliable data related to cash flows and expo- dampen both the growth of housing finance and de- sure to risks. This requires lenders to make significant press some specific housing submarkets--although investments in infrastructure, including in technol- they would not be expected to trigger a financial sec- ogy and procedures. Although the secondary market tor crisis as seen in 1997. In fact, the origination of agencies have encouraged standardization, this is mortgage loans at longer maturities at fixed interest not always the case in the region--in practice many rates in order to reduce the vulnerability of the finan- lenders have different credit policies, and portfolios cial system and to facilitate accessibility of housing are neither very well standardized nor documented. finance for lower income households is a key objec- Another technical difficulty to overcome is the TABLE 4.2 Mortgage Rates Offered by Banks in Selected Economies (2006, adjustable rates in percent) China Indonesia Malaysia Thailand Hong Kong, China 5.51 15.0­17.0 5.5­7.5 6.0­8.0 5.0­6.5 76 East Asian Finance establishment of conditions for the innovative 2. Covered bonds, which are issued directly by mortgage backed securities (MBS) to be treated as the banks as balance sheet funding instruments. The collateral for repo markets; this would enhance their rating of such bonds would need to be enhanced by liquidity and hence their attractiveness. In most coun- a cover pool of mostly safe mortgage loans (using the tries, there is also no private external credit enhance- matching principle64), and bond investors would ment system, including pool guarantees or individual have to have legal priority over other creditors in the mortgage insurance, which means that the structur- event of bankruptcy. This would enable large lenders ing of the transaction has to rely on expensive inter- to access the bond market under favorable condi- nal enhancements for the issuer (leaving little capital tions, without selling their best mortgage loan assets. relief) or public guarantees that transfer part of the Such products have been successfully developed in risk into fiscal liabilities. the Czech Republic, Denmark, Germany, and Hun- While efforts need to be made to accelerate the gary, and on a very large scale in Chile. However, the development of mortgage securitization, for coun- development of a covered bond market also requires tries that still have a considerable way to go in some minimum legal and regulatory framework to strengthening the building blocks needed to under- be in place to ensure both the bankruptcy privilege take complex mortgage-backed securitization on a and the matching requirement during the whole life large scale, other simpler forms of private mortgage of the bonds (including eligible mortgage assets, re- securities can be explored in the interim. Two main placing requirements, specific register for the cover areas to explore would be: assets, adjusted and disclosure and oversight systems, 1. Liquidity facility, which leaves the credit risk, etc.) in unambiguous terms to protect the interests along with most of the margin to the primary lenders of the investors. until a second phase of securitization can be reached Economies such as Hong Kong (China), Korea, (the Cagamas model in Malaysia until 2004 is an ex- Singapore, and Malaysia do have the key elements of ample, see box 4.3). Indeed, in addition to Malaysia, the infrastructure for MBS in place. Even in these other countries such as France, Mexico, Switzerland, economies, however, securitization of mortgage loans and even the United States (Federal Home Loan has been slow, because banks are flush with liquid- Banks) have successfully developed variants of this ity and have so far been reluctant to sell their model. profitable mortgage loans. This tendency has been BOX 4.3 Cagamas: The National Mortgage Corporation in Malaysia Cagamas Berhad was created in 1987 as a private specialized company to help housing lenders manage their financial risk and expand their lending, as well as to develop private bond markets. Capital has come mostly from the financial institutions, with 20 percent of the shares held by Bank Negara. The Company has been purchasing residential loans from competing lenders (most of the loans are adjustable rate loans) on a full recourse basis and for limited periods, funded by issuing private bonds. Cagamas has been operating more as a liquidity facility than a securitization conduit. Initially, key regulatory and stamp duties were granted to its refinanced loans and bonds to increase their attractiveness to financial institutions. The environment for its develop- ment has been favorable for the following reasons: (1) Malaysia is a relatively stable macro-economy; (2) there is a well- developed bond market infrastructure; (3) an efficient system of property title registration is in place; (4) there is a pro-active housing policy, which permitted the production of affordable housing; and (5) there are some well regulated and competitive private credit institutions. Its funding of mortgage markets reached 41 percent, at the peak of the crisis (operating as a private funding buffer in adverse times), which fell to 12.6 percent subsequently, as the more liquid banks mobilized alternative funding. Cagamas has played a catalytic role in improving the affordability of mortgage loans. It has been a major issuer of private bonds (at end-2005 it still accounted for 14 percent of total corporate bonds outstanding). The company has diversified its financing products as the market's needs have evolved. In addition to housing loans, it began to pur- chase conventional products in 1998 and 2001, respectively. The preferential treatment of debt instruments issued by Cagamas was removed to create a level playing field for other financial institutions and encourage Cagamas to enter into true securitization transactions. In response, in 2004, the Com- pany began securitizing the housing loans extended by the government to civil servants. Cagamas has also recently launched a landmark Islamic securitization transaction that has been very well received. Fostering an Efficient and Sound Banking Sector 77 reinforced by the adjustable rate nature of their port- exist in China, Indonesia, and Thailand). Also im- folios, which has limited their exposure to financial portant is the development of other savings and risks. Further market competition, the adoption of credit products, including the provision of housing Basel II, and increased awareness that securitiza- micro-finance, residential leasing loans (such as tion represents an effective risk management tool, the one initiated in Thailand through a hire pur- may gradually change this situation. chase program funded by the Government Housing Finally, in several countries in the region, there is Bank (GHB)); and contractual housing savings also an issue of affordability and access to housing by schemes that would help these households to low-income households and households that rely on build both equity and a favorable score from credit the informal labor market. Affordability is limited by institutions. high house prices, and high down-payment require- From the perspective of accessibility, it is also im- ments. High origination costs and high servicing costs portant to note that the development of housing fi- also act as a barrier against small loans. And in some nance is constrained by land supply rigidities and cases there is still a large number of households (low urban development regulations in some countries­ income and/or operating in informal labor markets) a situation in which housing prices rise faster than that are not served by banking services (see table 4.3). household incomes, despite favorable credit condi- As a result, even in countries where the size of the tions. Addressing this issue requires the develop- overall mortgage portfolio is decent, for example in ment of appropriate overall housing policy, Thailand, the majority of households still does not including land policy and housing regulations. An leverage debt from any credit institution but rather re- appropriate housing policy should also include a lies on equity-financed self construction. This results sufficient budgetary contribution to "smart" hous- in delayed and expensive access to home ownership. ing finance subsidies; subsidies that would be so- In Indonesia the estimated proportion of equity- cially targeted according to incomes and affordable financed self construction is as high as 65 percent. housing conditions, allocated in a transparent man- New initiatives in countries to introduce national ner, and be efficient in leveraging debt from the systems of mortgage default systems (as discussed market (not only from credit institutions but also by above) would help active housing lenders to better finance companies, savings associations, and micro manage their credit risks with fewer down payments lenders). from households. Another important element of in- Lending to corporations frastructure that is currently missing is the provision of consumer information packages. Bank lending to corporate entities has been muted A survey of housing finance markets in the region since the crisis. In part this reflects slow demand, both also suggests that the provision of several other because investment has remained low and because commercial loan products that are currently miss- firms have restructured and de-leveraged and fi- ing in several markets would help cater to the needs nanced a significant proportion of their capital needs of low-income households. These include indexed through retained earnings (Box 4.4). Firms have also loans (which would reduce the exposure of loans sought alternative sources of external financing as to inflation), and home equity loans (which do not financial markets in the region have broadened. For BOX 4.4 Progress in Corporate De-Leveraging and Corporate Performance Over the past few years, the financial health of corporations in East Asia has improved over several dimensions, with sig- nificant progress made in de-leveraging in the crisis-affected countries. As the table below shows, the median corporate debt-equity ratios were lower in 2001­4 than during the crisis and its immediate aftermath (1997­2000), as a result of corporate debt restructuring, a significant pay-down of debt by firms, and a strengthening of exchange rates. (The burden of debt denominated in foreign currency soared because of the massive devaluations of local currencies that took place during the crisis.) In some cases, debt levels have also fallen well below those in the pre-crisis period, 1994­96. Korea has seen the most dramatic reductions in corporate indebtedness, with median debt-equity ratios now only around one third of their pre-crisis levels. Thailand has also seen substantial declines in debt to pre-crisis levels. (Continued) 78 East Asian Finance BOX 4.4 Progress in Corporate De-Leveraging and Corporate Performance (Continued) 1994­96 1997­2000 2001­04 2003 2004 Debt to equity ratio (%) Median Mean Median Mean Median Mean Median Mean Median Mean China 46 55 48 63 56 76 59 79 62 86 Indonesia 71 82 140 289 65 150 64 145 68 140 Rep. of Korea 181 252 123 227 60 106 53 98 49 77 Malaysia 49 67 54 122 39 76 40 78 40 72 Philippines 39 63 61 113 51 106 45 138 55 70 Thailand 94 109 113 288 58 118 59 97 47 77 Hong Kong (China) 44 60 36 61 32 55 33 59 34 51 Singapore 38 50 46 67 37 61 38 60 54 35 United States 56 75 64 90 65 102 63 100 54 92 Interest coverage (median, %) China 4 4 4 4 4 Indonesia 3 1 2 2 2 Rep. of Korea 1 2 3 3 4 Malaysia 6 3 4 5 5 Philippines 5 1 1 1 2 Thailand 3 2 6 7 9 Hong Kong (China) 4 3 5 6 7 Singapore 6 5 7 8 10 United States 7 7 6 5 6 Return on assets (median, %) China 7 4 5 5 4 Indonesia 9 4 5 4 4 Rep. of Korea 6 5 5 5 5 Malaysia 8 3 4 4 4 Philippines 8 2 2 2 4 Thailand 7 3 8 8 9 Hong Kong (China) 7 4 4 4 5 Singapore 5 4 4 5 6 United States 8 9 7 7 8 Broadly speaking, lower debt-equity ratios should render firms less vulnerable to volatile economic conditions that drive them into insolvency and prevent them from servicing their debt. While debt-equity ratios give insight into the structure of the firm's balance sheet, interest-coverage ratios measure the impact of debt on the firm's income statement, showing the number of times the firm's profits cover interest payments on debt. (A low ratio indicates that the firm is vulnerable to shocks that reduce profits and may leave it unable to service debt.) The above table also shows that inter- est coverage has generally improved during the post-crisis period, with Korea and Thailand again showing the biggest gains. However, interest-coverage ratios remain relatively low in Indonesia and the Philippines. The average or mean debt-equity ratios in East Asia are generally higher than the medians. This indicates the pres- ence of a certain number of firms with extremely high levels of debt. However, the proportion of firms with very high debt levels has also been falling over time in most countries. Data on the median return on assets (ROA) in the table above provide some information on trends in corporate profitability. Profitability has generally been recovering slowly from the sharp declines suffered during the crisis, with ROAs remaining below their pre-crisis levels in most cases. In part the gradual pace of improvement in profits may be linked to the external shocks, such as the dot com crash and the steep downturn in the world high-tech industry in 2001 that came on the heels of the financial crisis. The gradual pace of recovery in profitability is consistent with the slow and erratic recovery of investment in the region. (Continued) Fostering an Efficient and Sound Banking Sector 79 BOX 4.4 Progress in Corporate De-Leveraging and Corporate Performance (Continued) Firms with debt/equity ratios over 200 percent 40 1997­2000 2001­04 30 20 firms of % 10 0 Indonesia Thailand Rep. of Malaysia Philippines Korea their part, however, banks may have become more have bank loans. The percentage of households with risk-averse. bank accounts is only slightly larger in the Philippines, Overall, while debt-equity ratios, interest-coverage but twice as high in Thailand, at almost 50 percent ratios, and profitability have been moving in the right of households.65 direction, there are still areas of vulnerability in the regional corporate picture. Examples include the rel- Microfinance atively low interest-coverage ratios in countries such A key challenge is to extend banking services to as Indonesia and the Philippines, a still-gradual pace lower-income households and very small enter- in the improvement of corporate profitability, and a prises. Providers of microfinance offer services to continued hesitation in undertaking new business lower-income people, typically in units smaller than investment on a substantial and sustained scale. the country's per capita GDP. In a number of coun- tries, governments have compelled banks to provide The reach of banking services microfinance, especially to sectors such as small or How good is access to and usage of bank services agricultural enterprises considered by the govern- in the region? As shown in Figure 4.7, banks in East ment to be social priorities. Often it has been diffi- Asian countries have achieved quite a broad reach, cult to find sustainable models of service provision, at least through a combination of bank branches and some banks that have attempted to serve this and automated teller machines. market have failed. Of course, access does not equal use, and without Increasingly, however, commercial banks around specific surveys it is generally difficult to obtain in- the world are entering the microfinance market formation on the use of bank services by households of their own accord, because they see opportunities or small firms. However, Beck, Demirgüç-Kunt, and there for sustainable profit and growth. Compared Martínez-Peria (2005) have predicted the share of with many providers of microfinance, commercial households that have bank accounts and the share of banks have several potential competitive advantages, small firms that have bank loans, based on econo- such as recognizable consumer brand names, exist- metric relationships, using the number of deposit and ing infrastructure and systems, and access to capital loan accounts in an economy at the aggregate level (CGAP 2005). (Table 4.3). Their results suggest that in Indonesia, Banks that have succeeded have used several for example, about 21 percent of households have different approaches to enter the market. These bank accounts, and about 39 percent of small firms can be divided into two main categories--direct 80 East Asian Finance FIGURE 4.7 Indicators of the Reach of Banking Services a. Bank branch demographic penetration b. ATM demographic penetration 120 160 140 100 120 people 80 people 100 1,000 60 80 per 100,000 40 per 60 40 branches TMsA Singapore 20 Philippines Thailand Rep. of Korea Malaysia 20 Malaysia Singapore Thailand 0 China Indonesia 0 China Indonesia 0 10 20 30 40 50 60 0 10 20 30 40 50 per capita GDP, thousands per capita GDP, thousands c. Bank branch geographic penetration d. ATM geographic penetration 700 3,000 Singapore 600 Singapore 2,500 500 km. km. 2,000 sq. 400 sq. 1,500 1,000 300 1,000 per per 1,000 200 Philippines Indonesia TMsA 500 100 Rep. of Korea Rep. of Korea branches Thailand Thailand Philippines 0 0 Malaysia Indonesia China China ­100 ­500 0 10 20 30 40 50 60 0 10 20 30 40 50 per capita GDP, thousands per capita GDP, thousands and indirect--based on how the bank makes con- infrastructure and systems, and their own business tact with clients. Some banks enter the market di- goals in choosing among these approaches. rectly though establishing an internal microfinance A number of considerations for policymakers unit, or a specialized financial institution, or a micro- arise if a country is to provide an environment that finance service company. Other banks deal with encourages the provision of microfinance by banks. clients indirectly, working through existing providers These are discussed in Box 4.6 later in this chapter, by outsourcing their retail operations, or provid- within the context of a broader discussion of policy ing commercial loans to microfinance institutions, issues for banking. or providing infrastructure and systems. Each of these approaches has its particular rationale, risk Services provided by banks profile, success factors, and costs. For banks to suc- All countries in the region allow banks to conduct ceed in microfinance, it is important that they take business in other segments such as securities, insur- into account factors such as the level of competition, ance, and real estate, albeit with varying degrees of the regulatory environment, market size, existing restrictiveness.66 With the consolidation that has Fostering an Efficient and Sound Banking Sector 81 TABLE 4.3 Predicted Shares of Households and Small Firms Using Banking Services Share of households with bank accounts Share of small firms with bank loans Economy (percent) (percent) Indonesia 20.7 39.1 Korea 65.2 n.a. Malaysia 60.0 51.0 (52) Philippines 22.6 n.a. Singapore 97.7 63.1 (60) Thailand 49.1 47.9 Memorandum: Bolivia 12.1 25.1 Chile 45.9 50.7 Lithuania 35.3 38.7 Spain 83.7 60.4 Turkey 48.5 41.5 Source: Beck, Demirgüç-Kunt, and Martínez-Peria 2005. Note: n.a. = not available. Numbers in parenthesis are based on actual survey data rather than econometric estimation. taken place in the banking sector in the region, banks creased (Table 4.1 above), there has been a large rise could be expected to undertake a broader range of in the median size of banks since the crisis, mea- services. sured in terms of either assets or deposits (Table 4.4). In principle, consolidation allows banks to exploit Indeed, in several economies in the region (Hong economies of scale, scope, organization, manage- Kong [China], Korea, and Thailand), the median ment, and product mix. Recent studies, albeit mainly bank is larger than in Germany, the United King- of U.S. banks, that have corrected for the additional dom, or the United States. risk-taking that often accompanies consolidation, Banks in the region have also significantly broad- have found evidence of economies of scale ranging ened their range of services. While it is difficult to from US$3­5 billion in asset size (Hughes and others gauge systematically the range of services that banks 1996, 1998).67 Consolidation can also allow banks to are providing, income statements make it possible to exploit economies of scope: the ability to offer clients assess the extent to which banks are now provid- one-stop shopping for different financial products ing fee- and non-fee-based services.68 The income- can produce synergies brought about by the integra- diversification index in the last column of Table 4.4 tion of different business units. These synergies can shows that the diversification of banking activities be broadly divided into cost reduction and revenue has increased particularly fast in Hong Kong (China), enhancement. On the cost-reduction side, the syner- Malaysia, the Philippines, and Thailand. gies include the sharing of fixed costs such as for Thus far, banks are not yet fully benefiting from branches, data processing, personnel services, or the consolidation. Analysis shows that the average per- use of customer information for multiple purposes formance of diversified banks is poorer than those of (for example, a bank can use information on deposit specialized banks. While some of the other structural behavior to assess a client's risks of bankruptcy and and policy changes have been beneficial (for instance, default). On the revenue-enhancement side, differ- banks that have greater foreign ownership and better ences in revenues between operations can be dis- capitalization perform better than other banks in the persed across multiple different divisions of the bank, region), banks that are larger and banks that are un- helping to spread risks. Customers, too, can benefit dertaking a broader range of activities are not yet from economies of scale, saving some of their bank- enjoying economies of scale and scope (Box 4.5). ing service expenses by using multiple services at Effectively reaping the benefits of consolidation the same time. This may increase demand and hence is a learning process and for many banks in the re- revenues. gion it is probably too early to see the results. How- How much consolidation has taken place in the ever, it is also important to note that the bulk of the region? Though concentration ratios have not in- consolidation that has taken place so far has been 82 East Asian Finance TABLE 4.4 Measures of Consolidation and Diversification of Banking Sector Activities Median size Median size Median market Income of assets of deposits share of assets diversification Economy (US$ billions) (US$ billions) (percent) index 1998 2004 1998 2004 1998 2004 1998 2004 Indonesia 0.2 0.8 0.1 0.6 0.4 0.7 0.46 0.45 Rep. of Korea 16.7 61.9 10.2 42.1 4.0 5.8 0.65 0.61 Malaysia 1.9 7.4 1.3 5.0 1.3 2.7 0.53 0.64 Philippines 0.4 1.3 0.3 0.9 0.8 2.4 0.57 0.65 Thailand 4.4 13.4 4.1 11.8 3.9 6.9 0.41 0.61 Hong Kong 3.3 5.0 2.3 4.2 0.9 0.6 0.43 0.61 (China) Singapore 2.2 0.8 1.9 0.8 0.8 0.2 0.40 0.41 Germany 1.0 1.9 0.9 1.7 0.03 0.03 0.60 0.65 United 1.2 2.3 0.9 1.8 0.03 0.02 0.63 0.61 Kingdom United States 1.4 2.2 1.0 1.5 0.01 0.01 0.46 0.49 Bolivia 0.3 0.2 0.3 0.2 n.a. n.a. n.a. n.a. Greece 4.4 3.6 3.2 3.1 n.a. n.a. n.a. n.a. Mexico 0.4 0.9 0.3 0.6 n.a. n.a. n.a. n.a. Turkey 1.0 3.7 0.8 2.6 n.a. n.a. n.a. n.a. Ukraine 0.0 0.3 0.0 0.3 n.a. n.a. n.a. n.a. Source: Bankscope. Notes: Income diversity averaged by country. Score of 1 denotes perfect diversity between commercial banking and investment banking activities; score of 0 denotes specialization in one activity. The index is calculated as: 1 - abs [(net interest income - other operating income) / total operating income], where abs denotes the absolute value. The index is averaged by country. n.a. = not available. BOX 4.5 Impact of Structural Changes on Banking Sector Efficiency: Empirical Analysis To shed light on the impact the structural changes and policy reforms are having on banks, cross-country regression analy- sis was undertaken on a sample of commercial banks in the region using data from their audited financial statements. The sample covers the largest publicly listed and private banks in the region.a The economies covered are Hong Kong (China), Indonesia, Korea, Malaysia, the Philippines, Singapore, and Thailand. In the analysis, the indicator of banking sector efficiency that is used is the ratio of operating income to total as- sets. However, because the performance of banks can differ depending on the diversity of activities they engage in, it is important to adjust the performance indicator for the type(s) of activities banks undertake. For example, if un- derwriting securities generates more income than lending, then a bank that does both may have a higher operating income than a bank that only makes loans. Thus an activity-adjusted ratio of operating income to total assets was constructed as: Activity adjusted j = j 1 + 1- j ; 1 ( 1) 2 Where j is the estimate of operating income to total assets of bank j, and j1 is the share of "commercial banking activity" of bank j, so that (1 - j1) would be the share of "investment banking" activity. The impact of the bank's ownership structure (state-owned, private domestic, or foreign-owned), size (to examine the potential for economies of scale), and diversity of activities undertaken (to examine the potential for economies of scope), was examined, controlling for country-specific banking regulations as well as bank-specific variables (such as capital- adequacy ratios and liquidity ratios). The results from the regression analysis are summarized below. (Continued) Fostering an Efficient and Sound Banking Sector 83 BOX 4.5 Impact of Structural Changes on Banking Sector Efficiency: Empirical Analysis (Continued) Dependent Variable: Ratio of Operating Income to Total Assets (activity-adjusted) Coefficient Private domestic ownership 0.002 Foreign ownership 0.007a Log of total assets (measure of size and economies of scale) -0.001 Income diversity (measure of activity diversity and economies of scope) -0.037c Deposits/liabilities 0.014 Equity/assets 0.076b Growth in total operating income (lagged) 0.013c Banking policy 0.003 Fiscal policy 0.017c Monetary control 0.003b Price discipline 0.005a Property rights 0.005 No. of observations 1398 R squared 0.47 Notes: Operating income is gross income before operating costs (including personnel expenses) and before taxes. It includes net interest income and income from fees, commissions, and trading income. Given data limitations, it is not possible to distinguish between securities underwrit- ing, brokerage services, and insurance underwriting; instead a distinction is made simply between lending and non-lending activities based on income statements. The income-diversity index therefore measures the diversification across different sources of income and is calculated as 1­(net interest income­other operating income/total operating income), where net interest income is interest income minus interest expense, and other operating income includes net fee income, net commission income, and net trading income. Income diversity also takes values from 0 to 1, with higher value indicating greater diversification. a. Significant at the 10 % level. b. Significant at the 5% level. c. Significant at the 1% level. The results suggest the following: Ownership Private domestic banks perform slightly better than state-owned banks, although the difference is not statistically sig- nificant. Foreign-owned banks are found to perform much better than state-owned banks and the difference is statis- tically significant. The results suggest that an increase in foreign ownership of 10 percent would cause performance to improve by about 7 percent. This is a large effect, considering that the average ratio of operating income to total assets in the sample banks is about 4 percent. There has been considerable debate about the impact of foreign banks on the domestic economy (Box 4.4 below), but in general most empirical work finds that in emerging markets and develop- ing countries, foreign banks tend to perform better than domestic banks and also raise the efficiency of the domestic banking sector. Consolidation Size. The analysis does not point to any benefits from an increase in banks' asset size: the coefficient is not statistically significant and is negative. Diversity of activities. The analysis also does not point to banks benefiting from economies of scope. The coefficient in income diversification is negative and statistically significant. Thus the operating income of banks that engage in multi- ple activities is much lower than it would be if those banks were broken up into financial intermediaries that specialized in the individual activities. a. To ensure the comparability of the banks in the sample, it is limited to banks identified by Bankscope as commercial banks, savings banks, and bank holding companies with major commercial banking operations. Data are from Bankscope. Source: Laeven 2005. 84 East Asian Finance government-led (Appendix Table 4.3). If consolida- ness: for example, if there are sizable economies of tion is to be accompanied by improvements in per- scale, the fact that there are only a handful of banks formance, it is important to ensure that the banking could actually be a reflection of a competitive mar- system in the region operates within a competitive ket in which only a few banks can be profitable. Per- environment. formance measures such as the size of banking margins, interest spreads, or profitability are simi- larly inadequate, because they are influenced by Improving the Efficiency and factors such as a country's macroeconomic perfor- Enhancing the Reach of the mance and stability, the form and degree of taxation Banking Sector of financial intermediation, and the quality and As noted, banks in the region have yet to see perfor- availability of information systems. mance benefits from the consolidation that has taken Rather, testing for the degree of effective com- place and from the more diversified fee and non-fee petition requires a structural, contestability-based based activities that many are undertaking. It is im- approach whereby the degree of competition is mea- portant to ensure that the policy environment is sured with respect to the actual behavior of (mar- conducive to competition and provides incentives ginal) bank conduct. Actual behavior is likely to be for banks to undertake activities based on consider- related not only to the market structure but also to ations of profitability, rather than simply in order to entry barriers--including barriers on foreign own- be in a particular line of business. ership, branching restrictions, and the severity of re- Neither have banks in the region fully resumed strictions on activity in the financial sector--since lending to the corporate sector. As discussed above, the latter can limit the degree of intra-industry com- this largely reflects the muted demand from that sec- petition (say from non-bank financial institutions) tor, but it also reflects risk aversion on the part of and exit policies, or in other words, the degree to banks. Making more information available, and which the markets are "contestable." facilitating information sharing among creditors, as Based on such an approach, Figure 4.8 shows the well as strengthening other legal and institutional degree of competition in East Asian banking. The underpinnings, along with the regulatory and super- H statistic provides a measure of the degree of com- visory framework, will be important in facilitating petitiveness in the system, with less than zero indi- the resumption of lending to creditworthy corpora- cating a perfect monopoly, less than 1 indicating tions and in enhancing the provision of bank finance monopolistic competition, and 1 indicating perfect to a wider set of borrowers. It is also important that competition. The average H statistic for the East Asia banks have the incentive to use the capital markets region is around 0.7, which is close to the worldwide to manage and diversify their risks appropriately. average of 0.72 and somewhat below the high-income OECD countries' average of 0.8. Improving efficiency While the banking sectors in Hong Kong (China), Korea, and Singapore appear to be very competitive, In banking as in other sectors of the economy, the degree of competition is generally found to be an at the other end of the spectrum the degree of com- important determinant of performance--not only petition currently facing Thai banks is rather low of efficiency in the provision of financial services, (with an H statistic of around 0.2). but also in the quality of products and the degree of In Hong Kong (China), Korea, and Singapore, innovation in the sector.69 markets are contestable in terms of having regula- tions that facilitate entry and exit (including by for- How competitive are the banking systems eign banks), although Singapore's law does not in East Asia today? specify levels of solvency that trigger automatic in- The competitiveness of an industry cannot be tervention by regulators (Figure 4.9). All three ju- measured simply by indicators of structure and risdictions also have relatively low state ownership performance. Although commonly used, market- (and high foreign ownership) in their top ten banks structure indicators such as the number of institu- (see Table 4.1). tions, or the Herfindhal or other concentration Next in terms of the competitiveness of the bank- indexes, are not an adequate guide to competitive- ing system is Malaysia. Malaysia has some restrictions Fostering an Efficient and Sound Banking Sector 85 has the smallest share of average foreign ownership FIGURE 4.8 Degree of Competition in Banking in its top ten banks of any country in the region ex- cept China. In Indonesia, the issue appears to be Degree of competition in banking sectors the still-high state ownership in the banking sector, which likely reduces the extent to which banks H statistic operate in a competitive environment. 1.0 Thailand has entry restrictions and no mecha- nisms that facilitate exit (either pre-determined levels 0.8 of solvency deterioration that lead to intervention, or cease-and-desist-type orders). Also, average foreign ownership is relatively low and, perhaps more im- 0.6 portantly, state ownership in the banking sector is still very high, probably reducing competitive pressures. competition 0.4 Approaches for enhancing competitiveness To enable East Asian banks to position themselves increasing 0.2 appropriately in the global arena it is important to ensure that the environment facing banks in the re- gion is a competitive one. The global landscape in 0.0 banking is changing rapidly, driven by innovation in ChinaKorea information technologies, marketing channels, and Thailand Indonesia PhilippinesSingapore Malaysia of economies economies financial engineering. Banking systems in advanced Kong,Rep. countries will likely become even more competitive. Hong AsianOECD East Banks operating in a competitive environment will have the incentive to ensure that any consolidation Average high-income or diversification of business activities is based on Average considerations of efficiency and profitability. Source: Laeven 2005. Clearly, the pace at which competitive forces can Note: The H statistic is based on the approach of Rosse be enhanced without jeopardizing the stability of the and Panzar (1977) and Panzar and Rosse (1982 and 1987). This methodology uses bank-level data to in- banking systems will partly depend on the progress vestigate the extent to which a change in factor input made in strengthening the institutional underpin- prices is reflected in the (equilibrium) revenues earned by a specific bank. Under perfect competition, an nings of sound financial systems: information dis- increase in input prices raises both marginal costs and closure, and accounting and auditing practices, as total revenues by the same amount as the rise in costs. Under a monopoly, an increase in input prices will well as on effective implementation of prudential increase marginal costs and reduce equilibrium output regulation and supervision. and hence total revenues. Certain barriers to entry in the banking sector are of course motivated by prudential considerations. Most countries in the world have legal requirements before a bank license can be issued, such as draft by- on foreign bank entry. It does not have cease-and- laws, intended organization chart, financial projec- desist type mechanisms, nor pre-determined levels of tions, financial information on the potential largest solvency that trigger regulators' automatic interven- shareholder, and backgrounds of the intended direc- tion. Thus contestability in banking may be said to be tors and managers. lower in Malaysia than in Hong Kong (China), Korea, But the value of imposing other barriers that or Singapore. However, the average state ownership primarily tend to limit competition is more debat- of banks in Malaysia is relatively low, and average for- able. The issue of foreign bank entry in particular eign ownership in the top ten banks is 26 percent. has been subject to debate (Box 4.6). The bulk of the The Philippines and Indonesia rank next. The evidence suggests that foreign bank entry enhances Philippines has some restrictions on entry, and also the efficiency of domestic banking systems, both 86 East Asian Finance FIGURE 4.9 Regulations Affecting Ease of Entry and Exit Restrictions on entry and exit affecting contestability 12 lack of predetermined levels of solvency deterioration regulations affecting entry 10 8 x de 6 in 4 2 0 Indonesia Rep. of Malaysia Philippines Thailand Hong Kong, Singapore United United Korea China Kingdom States Source: Barth, Caprio, and Levine 2005. Note: score on restrictions on exit is derived as follows: since the lack of predetermined levels of solvency deterioration that forces automatic action by regulators in the law, and the lack of cease-and-desist-type orders whose infraction leads to automatic imposition of sanctions, reduces the pressures of exit, a score of 1 is given to a country that lacks each of these. by increasing competition and through positive by easing the entry/exit of institutions both domes- spillovers, although the extent of these benefits may tic and cross-border; a functional approach, which depend on conditions in the domestic banking sector. would ensure contestable markets by leveling the In particular it is important to ensure that domestic playing field across similar financial products (in all banks are reasonably healthy prior to large-scale entry dimensions); and a production approach, which by foreign banks. In the region, China, Malaysia, would ensure efficiently provided and equally acces- the Philippines, and Thailand still restrict the entry sible network services--information distribution, of foreign banks (Appendix Table 4.2).70 Malaysia's clearing and settlement, payments--to take account financial sector master plan envisages lowering entry of any network externalities. So far, countries across barriers on foreign banks in its second phase. the world have focused primarily on the institutional Going forward, appropriate competition policy in approach, and to a limited extent, the functional the region will continue to become more compli- approach. cated. Financial deregulation, the internationaliza- However, even when attempts have been made to tion of financial services, and technological advances level the playing field for financial service providers have made product definitions and their associated and across financial services (using the functional markets less clear and have blurred the distinction approach), regulatory and other differences may between many classes of suppliers in providing spe- continue to create barriers to full competition. Dif- cific forms of financial services. ferent players may face different standards, for exam- In view of these developments, competition policy ple if regulations require capital for local branches of ought to combine three approaches: an institutional foreign banks but not for branches of domestic banks. approach, which would ensure contestable markets Information requirements may differ by product; for Fostering an Efficient and Sound Banking Sector 87 BOX 4.6 Effects of the Entry of Foreign Banks: Cross-Country Findings Foreign bank entry refers to the process by which foreign banks set up operations in a host country. Desired forms of entry may vary from bank to bank and from country to country, depending on business strategy considerations and the host country's laws and banking structures. Banks may open a representative office, a branch, or a subsidiary, either as a new operation or by acquiring a domestic bank. Impact on development and efficiency of domestic banks The entry of foreign banks has generally had favorable effects on the development and efficiency of domestic banks and host-country banking systems (Micco, Panizza, and Yanez 2004; Mian 2003). Foreign banks that expand abroad are typ- ically the "best of the crop" in the country of origin (Focarelli and Pozzolo 2000), and hence they are likely to export im- proved management and information technology practices and directly enhance the efficiency of the banking sector. Foreign banks exert competitive pressures on domestic banks, often inducing the latter to reassess their business prac- tices, including local lending practices. The result can be better risk management, more competitive pricing, and in gen- eral, over the medium run, a more efficient allocation of credit in the financial sector as a whole. The generally positive effects of the entry of foreign banks have occurred through various channels: · While foreign banks tend to diminish the profitability of domestic banks, they also tend to improve their efficiency. For instance, a study by Claessens and others (1998) looks at the effects of foreign banks in a sample of 80 developed and developing countries and finds that while foreign banks diminish the profitability of domestic banks, foreign entry also reduces the non-interest income and overall expenses of domestic banks. Controlling for other variables, the high profits of the domestic banks before the increased foreign bank entry tend to reflect a lack of competition and lack of efficient management. · There is also some evidence of improvement in the quality of financial intermediation. For example, one observes less loan-loss provisioning with more foreign bank entry (Martínez-Peria and Mody 2004). · The qualitative effects of the entry of foreign banks have by nature been harder to document, but may have been most important. They include the emergence of new, more diverse products, the greater use of new technologies, and spillovers of know how (for example, as people learn skills in foreign banks and subsequently move to jobs in local banks). Foreign banks have also exerted pressure to improve regulation and supervision, and increase transparency, and more generally appear to be a catalyst for reform (Levine 1996 and Dobson 2005). The effects of foreign bank entry on the development and efficiency of a country's banking sector appear to depend on some initial conditions. The general level of development and any remaining barriers to entry and activity can hinder the effectiveness of foreign banks (Garcia-Merro, Herrero, and Martínez-Peria 2005; Demirgüç-Kunt, Laeven, and Levine 2004). The proportion of foreign banks in the country's banking system also matters; where this is small, fewer spillovers seem to arise, suggesting some threshold effect (Claessens and Lee 2003). It should be noted that these effects of the entry of foreign banks are not necessarily effects on competitiveness, since the studies mentioned above are not tests of formal competition models. Fully specified empirical studies of competi- tiveness are scarce, and are mostly for single countries. Limited though it is, the cross-country evidence using formal em- pirical contestability tests suggests that foreign bank ownership is the most consistent fact associated with improved competitiveness in local banking systems (Claessens and Laeven 2004). Next most important in enhancing competition is a relaxation of severe entry and activity restrictions on banks. Impact on access to finance How foreign bank entry affects access to banking services is less clear. Generally, it has been found that access is en- hanced by the direct provision by foreign banks and indirectly through the pressure that foreign banks put on domestic banks. For example, firms report fewer financing obstacles in countries with more foreign banks (Clarke and others 2001; Beck, Demirgüç-Kunt, and Maksimovic 2004). There is some evidence to the contrary, however: Detragiache, Gupta, and Tressel (2005), for example, find that foreign banks' presence in low-income countries leads to a reduction in credit and higher operating costs. Does the entry of foreign banks improve access to finance by small- and medium-size firms (SMEs)? In general, for- eign banks appear to allocate greater shares of their lending to commercial and industrial loans, suggesting that they may prefer lending to large companies. One reason why foreign banks may shy away from lending to SMEs is that most banks with an international presence are large. For large banks, organizational diseconomies may make it difficult to provide relationship-lending services to small enterprises while simultaneously serving larger clients' needs for transaction lend- (Continued) 88 East Asian Finance BOX 4.6 Effects of the Entry of Foreign Banks: Cross-Country Findings (Continued) ing and wholesale capital-market services. Substantial evidence from the United States indicates that large (though not necessarily foreign) banks lend relatively less to SMEs than do smaller banks (Berger and Humphrey 1995). However, some recent studies find that lending by foreign banks to small- and medium-size enterprises is growing. This trend is perhaps encouraged by technological advances that both reduce the need for banks to have a physical presence in all ge- ographic areas in which they lend (Petersen and Rajan 2000), and help large foreign banks overcome the diseconomies and difficulties of lending to small borrowers. Even if, in most developing economies, foreign banks continue to focus on serving large customers, foreign entry might still benefit small borrowers for several reasons. Besides the benefits associated with greater banking efficiency, foreign bank penetration could indirectly improve borrowers' access to credit through its effect on domestic bank lend- ing. Foreign bank competition for large customers could displace some domestic banks, forcing them to seek new mar- ket niches, such as providing credit to small- and medium-size enterprises. A study by Clarke and others (2001) is one of the first to try to capture both the direct and indirect effects of foreign bank entry on access to credit, and is based on a survey of about 3,000 enterprises in 36 developing and transition economies. Controlling for a large range of macro- economic, institutional, and firm-specific factors, it finds that firms in countries with greater foreign bank penetration tend to view interest rates and access to long-term loans as smaller constraints on operations and growth than do firms in countries with less foreign bank penetration. Moreover, although some evidence suggests that entry by foreign banks benefits large enterprises more than small ones, there is strong evidence that even small enterprises experience a net gain and there is no evidence that they are harmed by foreign entry. Implications for stability The entry of foreign banks generally improves the stability of a banking system. There appears to be less risk of financial crises, and banks--foreign as well as domestic--display higher provisioning and fewer nonperforming loans, suggest- ing better lending (Demirgüç-Kunt, Min, and Levine 1998; Barth, Caprio, and Levine 2005). There is also evidence of less pro-cyclical lending behavior in the local operations of foreign banks relative to the cross-border operations of foreign banks (Goldberg 2005), and less sensitivity to the risk of financial contagion (Goldberg 2002). There are also some pos- sible negative effects. Franchise value may be reduced, although such reductions are often hard to determine, given the recent entry in many markets (Boyd, De Nicolo, and Smith 2004). There can also be the risk of undiversified home coun- tries' effects, which occur when home-country macroeconomic shocks affect the foreign banks' lending in the host coun- tries (Buch, Carstensen, and Schertler 2005). However, the potential negative effects have to be weighed against having an undiversified domestic banking system without foreign entry. Source: Claessens 2006. example, securities products may require more in- What would the banking systems in the region formation disclosure than pension products, even if look like with greater contestability and competi- these products are otherwise similar. Pension savings tion? To get some indication, one can perhaps look may be taxed very differently from other forms of at the experience of the United States, where the savings, even though they are in many ways equiva- banking sector was heavily regulated and has pro- lent financial instruments. gressively been deregulated over the past 15 years or These are factors that the region will increasingly so. U.S. banks have developed a wide range of busi- need to take into account to ensure the efficient pro- ness strategies, made possible by the deregulation as vision of financial services. At present, as noted ear- well as by advances in information technology and lier, banks that have a narrow range of activities are new financial processes. Changes in the policy envi- more profitable than those offering more diverse ronment allowed banks to set deposit rates accord- services. Global experience suggests that the latter ing to market forces, expand into neighboring cities will develop the requisite expertise over time. But and states, and offer financial products whose pro- it is also important to ensure that other financial vision was previously reserved for non-bank institu- institutions can compete on a level playing field tions. As a result, commercial banks now compete in providing fund-management and securities ser- vigorously with each other as well as with investment vices, so as to provide competition and enhance the banks, securities firms, and insurance companies, and efficiency with which banks provide these services. differentiate themselves from each other in size, geo- Fostering an Efficient and Sound Banking Sector 89 graphic scope, organizational structure, product mix, support a relatively large number of banks serving funding sources, service quality, and customer focus. niche markets at the domestic level. Broadly speaking, two generic banking strategies have emerged. Being large allows a bank to achieve low Broadening access to banking services unit costs through scale economies. Large banks tend to provide more standardized products based on What key policy measures can help to broaden ac- hard information. Small banks offering traditional cess? Empirical studies have found that the legal and banking services operate in local markets, develop institutional underpinnings discussed in Chapter 3-- close relationships with their customers, and provide including the extent and quality of information dis- more customized products (Figure 4.10). Interest- closure and information sharing (credit registries ingly, on a risk-adjusted basis, profitability does not and credit bureaus), creditor rights, and the function- differ significantly across the two groups. Thus while ing of the legal system overall--have a strong bearing the large banks enjoy higher returns they also face on the availability of bank finance (Box 4.7). greater risks; the smaller banks show lower returns A key challenge for banks in the region is to move but also face lower risks. away from the largely relationship-based approach To some extent, these strategies correspond to dif- that has characterized their lending in the past, ferent segments of banking. The two segments face toward a more rule-based approach that is better different levels of competition and the number of suited to the needs of growing and increasingly glob- banks is likely to vary accordingly. Retail banking has alizing economies. While relationship-based lend- a stronger local dimension, with greater entry barriers ing can be useful in simple economies with limited and switching costs, so that there is still room to exer- mechanisms for designing and enforcing contracts, cise some market power--despite the erosion of mar- the high costs of screening and monitoring under ket power by electronic banking and information relationship-based lending are likely to limit the technology. Wholesale and investment banking, by access of firms and individuals.71 contrast, is a global segment with strong competition As more banks enter the microfinance business, where only a relatively small number of players can policymakers also need to consider a range of issues survive. Thus, in principle, while growing competi- that affect the viability and sustainability of micro- tion will likely lead to greater consolidation--with finance lending (Box 4.8). only a handful of banks operating at the regional (and possibly the global) level in the wholesale and invest- Ensuring the Stability ment banking segment--the retail segment is likely to of the Banking System As noted earlier, while the health of banks in the re- gion has strengthened since the crisis, the average FIGURE 4.10 Schema of Different Banking Strategies ratio of nonperforming loans in the region as a and Bank Size whole remains higher than that in other regions such hard information quality soft as Emerging Europe or Latin America. Moreover, there remains considerable variation in portfolio small high quality and NPL ratios across countries and across banks within countries. The region has undertaken significant efforts to size cost upgrade prudential regulation and supervision since the crisis. Nonetheless, based on a review of the im- unit plementation of the Basel Core Principles for Bank- ing Supervision (BCP), there are several areas in large low which fewer than 60 percent of the countries are com- standardized product differentiation personalized pliant or largely compliant (Figure 4.11): Source: DeYoung, Hunter, Udell 2004. · Objectives, autonomy, powers, and resources of supervisors: BCP 1.2, which deals with the skills, 90 East Asian Finance BOX 4.7 Factors Affecting Availability of Bank Finance: Cross-Country Findings Several empirical studies have looked at the relationship between access to and use of banking services and the business environment and corporate governance. The relationship between indicators of bank outreach (the provision of bank branches and automated teller machines) and measures of financial, institutional, and infrastructure development is ex- plored on a cross-country basis by Beck, Demirgüç-Kunt, and Martínez-Peria (2005). They find that greater outreach by banks is correlated with a country's level of overall financial development and its level of economic activity, suggesting some economies of scale in banking. Controlling for these factors, greater outreach is associated with the quality of the legal and institutional environment in the country at large, more effective sharing of credit information, and fewer re- strictions on banks' activities (banks may be less likely to expand their branch network if they are restricted to their core business of deposit taking and lending). Several studies look at the impact of the business environment, corporate governance, and access to finance from the perspective of firms. For example Beck, Demirgüç-Kunt, and Maksimovic (2005) find that financial, legal, and corruption problems particularly affect the growth of small firms. They find that small- and medium-size firms are significantly and negatively affected by--among other factors--high collateral requirements, bank paperwork and bureaucracy, and the need to have special connections if they are to meet their banking requirements successfully. Shortcomings in the legal system also affect the growth of small- and medium-size firms disproportionately, as does corruption. Love and Mylenko (2003) look at the impact of credit registries on the financing constraints of firms. They find that the existence of private credit registries is associated with lower financing constraints of firms and a larger share of bank financing. They also find that small- and medium-size firms tend to have a larger share of bank financing where private credit registries exist and that a stronger rule of law is associated with more effective private credit registries. They also find some evidence that the presence of a public credit registry benefits younger firms more than older firms. Galindo and Miller (2001) study how the quality of information in the registry affects financing constraints for firms in Latin America. They find that the index of the information coverage in the credit registry is associated with a reduction in the sensitivity of investment to the availability of internal funding, indicating better access to credit. Finally, Beck and Love (2005) use several indicators to look at the availability of finance to firms--that is, whether firms have access to bank credit to finance working capital or investment, and to a line of credit. Using the latest avail- able firm-level data from a series of investment-climate assessments conducted by the World Bank during 2000­04, they find greater investor protection, greater availability of credit information, and more efficient contract enforcement (fewer procedures mandated by the law, less time needed, and less need for costly court procedures) to be positively associated with the availability of bank credit and overdraft facilities.a Also, as in other studies, they find that regulatory burdens and restrictions on banking activity reduce the availability of credit and overdraft facilities while a strong rule of law and control of corruption are positively associated with credit and overdraft availability. a. Since this sample is taken only from developing countries, it does not include many of the "best practice" cases, so that several of the in- dicators that have been found to be statistically significant in other studies with more balanced samples are not found to be so here, because of lack of variation. Even so, most variables turn out to be either significant at conventional levels (at least at the 10 percent confidence level) or close to being significant (15 percent confidence level). The advantage of the sample is that it uses the most recent data. resources, and independence of the supervisory sions and reserves; BCP 9, which sets out the rules agency; BCP 1.3, which deals with the legal frame- for identifying the limiting concentrations of ex- work for banking supervision; BCP 1.4, which posures to single borrowers or to groups of bor- deals with the enforcement power of supervisors; rowers; BCP 10, which sets out rules for lending BCP 1.5, which deals with the legal independence to connected or related parties; BCP 11, which re- of supervisors; and BCP 1.6, which deals with in- quires banks to have policies for identifying and formation sharing among supervisors. managing country risks; BCP 12, which requires · Licensing and structure: BCP 3, which deals with li- banks to have systems to measure, monitor, and censing criteria and process for banks, and BCP 4, control market risks; BCP 13, which requires which requires supervisors to have the power to re- banks to have systems to measure, monitor, and ject all significant transfers of ownership in banks. control all other material risks; BCP 14, which · Prudential regulations and requirements: BCP 8, calls for banks to have adequate internal control which sets out the requirements for evaluating systems; and BCP 15, which sets out rules for the asset quality and the adequacy of loan-loss provi- prevention of fraud and money laundering. Fostering an Efficient and Sound Banking Sector 91 BOX 4.8 Enhancing the Environment for the Provision of Microfinance by Banks Enabling regulations · Licensing categories. It is important for countries to have a "small bank" category and thus enable financial institutions including rural banks, credit unions, or other types of finance companies to engage in microfinance. It is also important to "allow" nongovernmental organizations (NGOs) to exist since they can also be important in providing microfinance. · Minimum capital requirements. The social importance of encouraging microfinance provides an argument for fixing lower minimum capital requirements. If the minimum capital requirements are too high, there will few entrants and they will most likely seek wealthier clients, similar to those served by the larger commercial banks. On the other hand, if the minimum capital requirements are too low there will be too many weak entrants. This happened when the Philip- pines set up a rural bank license, which led to the entry of hundreds of small, weakly capitalized rural banks. The in- tention was to expand outreach, particularly in the rural areas, but it is not clear whether this has been achieved. Given their weaknesses, these banks have remained quite small, and it is only recently, with substantial technical assistance from donors, that they have begun to grow. · Branching restrictions. Allowing a "small bank" category on a national scale is particularly useful since these entities can then expand into a dynamic market or benefit from economies of scale. Often, as in Indonesia and the Philip- pines, regulatory authorities license small institutions to operate only in one particular municipality or region, as a pru- dential measure. Highly localized institutions also run the risk of having a portfolio that lacks sectoral diversification. Moreover, the competition created by allowing the more dynamic and aggressive small banks to move into other regions can also help make these institutions more cost-efficient. · Interest-rate caps. Small loans are costly and legal limits on loan interest rates usually make commercially viable microfinance impossible. Institutional infrastructure · Credit information bureaus are important for the banking sector as a whole, and should be as inclusive as possible. As noted earlier, information registries should have positive data and should include small loans. Ideally they should also cover all entities: credit cooperatives, rural banks, nongovernmental organizations, commercial institutions, and gov- ernment credit programs (which are especially relevant in East Asia). FIGURE 4.11 Compliance with Basel Core Principles for Banking Supervision Framework for East Asia supervisory objectives advanced industrial Supervision of foreign establishments Independence Host country supervision 100 Legal framework for supervision Global consolidated supervision 80 Enforcement powers Remedial measures Legal protection 60 Accounting standards Information sharing among supervisors 40 Consolidated supervision Permissible activities of banks 20 Validation of information Licensing criteria 100 80 60 40 20 0 20 40 60 80 100 Off-site supervision Transfers of ownership in banks 20 Contacts with bank management Review of banks investments 40 On-site and off-site supervision Capital adequacy 60 Anti-money laundering Credit policies Internal control and audit 80 Loan evaluation Other risks 100 Large exposure limits Market risk Connected lending Country risk Note: the numbers on the radial axis show the percentage of countries that are largely or fully compliant with a particular BCP. Thus for example, on supervisory independence (BCP1.2) 60 percent of the EAP countries were found to be fully or largely compliant and 100 percent of the advanced industrial countries were found to be largely or fully compliant. 92 East Asian Finance · Methods of ongoing supervision: BCP 16, which moves the incentives for depositors to monitor defines the overall framework for on-site and banks and their risk-taking. off-site supervision; BCP 18, which sets out the Indonesia, Korea, Malaysia, and Thailand all requirements for off-site supervision; BCP 19, adopted blanket guarantees on deposits after the fi- which requires supervisors to conduct on-site nancial crisis, but are now rolling back their guar- examinations; and BCP 20, which requires the antees in favor of a limited deposit insurance system. conduct of consolidated supervision. At the same time, countries in the region that his- · Remedial measures and exit: BCP 22, which re- torically had no deposit insurance have either re- quires supervisors to have and promptly apply cently established, or are establishing, limited systems adequate remedial measures for banks when banks (Table 4.5). Several of their deposit schemes incor- do not meet prudential requirements or are porate some of the key elements of good deposit in- otherwise threatened. surance schemes, and Hong Kong (China)'s planned · Cross-border banking: BCP 23, which requires scheme is probably closest to having these features. supervisors to apply global consolidated super- vision over internationally active banks; and BCP Meeting new challenges 24, which requires supervisors to establish con- tact and exchange information with other super- It is important that the remaining weaknesses in the visors, such as host country authorities, that are implementation of prudential regulations and su- involved in international operations. pervision be addressed promptly, particularly since new challenges are likely to arise. Of course, the overall incentives and framework As noted above, banks in the region are increas- for corporate governance--which are determined ingly involved in new areas of business, particularly at least partly by policies and regulations in the in retail and consumer finance. As Korea's experience broader economy--play a critical role in ensuring with credit-card lending during 2000­2 showed, a the effective implementation of prudential regula- very rapid increase in a new area of business raises tions and supervision and of adequate monitoring the stakes on the ability of financial institutions to by the market, and hence in fostering a sound bank- correctly assess credit risks. Many banks in the re- ing sector. For instance, even if their rights are well gion still have relatively weak capacity to identify, defined, creditors and shareholders (and other stake- monitor, and manage risks. holders such as depositors) will be less motivated to monitor financial institutions when there is a widely Promoting competition held perception that these institutions will ulti- While enhancing competition in banking will be im- mately be bailed out by the government. In the same portant from an efficiency perspective, greater com- vein, supervisors (even if they have broad supervi- petition is also likely to heighten the importance of sory powers) will have fewer incentives to exercise effective risk management by banks and of super- their powers appropriately unless they have legal pro- vision by the authorities. tection, as provided by the BCPs on the one hand and As discussed above, encouraging the entry of for- their own accountability to governing bodies and the eign banks can be an important means to promote public on the other. Indonesia, Korea, Hong Kong greater competition and contestability. As the pres- (China), Malaysia, and Singapore offer legal protec- ence of foreign-owned banks grows, the complexity tion to supervisors. However, as noted above, the in- of the tasks facing supervisors is likely to increase. dependence and legal protection of supervisors is The challenges for supervisors include: (1) choosing one area where countries in the region on average licensing policy and appropriate tests for managers are still relatively weak. and owners of complex holding companies or in- Depositors' incentives to monitor banks are vestment funds; (2) effectively monitoring the local strongly shaped by the existence of a deposit insur- establishment of large international banks or com- ance system. Such a system needs to be carefully de- plex financial institutions; (3) upgrading their super- signed (Box 4.9). By guaranteeing depositors against visory capacity to oversee complicated financial loss, deposit insurance removes the incentives for products of banks; (4) dealing with the issue of depositors to participate in a bank run, but it also re- support by parent banks in case of difficulties of a Fostering an Efficient and Sound Banking Sector 93 BOX 4.9 Deposit-Insurance System: Features of Good Design Cross-country evidence suggests that the following features enhance market discipline and reduce moral hazard: · Credibly low coverage limits per account; · Narrow coverage (e.g., excluding interbank deposits); · Coinsurance (and alternative private loss-sharing arrangements such as subordinated debt and extended stockholder liability); · Compulsory membership; · Ex post funding; · In the event of a crisis, targeting surviving banks to cover losses (although taxpayers may be asked to assist banks in a truly systemic crisis); · Private-public joint management. Limiting coverage in a credible manner ensures that identifiable groups of private individuals--large depositors, sub- ordinated debt holders, or other banks--understand that their funds are inescapably at risk. This exposure to potential loss gives them an incentive to monitor the behavior of both banks and safety-net managers. Compulsory membership increases the size of the insurance pool and prevents low-risk institutions from opting out of the system. This means that low-risk, well-managed banks can help supervisors to monitor higher-risk, less well- managed competitors. It is perhaps more difficult to convince countries to have a deposit insurance system with ex post funding and the in- volvement of the private sector in its design and management. Lack of immediate access to a pool of accumulated liq- uid reserves threatens to prevent authorities from dealing with insolvent institutions in a timely manner. However, cross-country evidence indicates that in weak institutional environments, the net economic value of deposit insurance reserves is routinely overstated, by failing to account for the implicit liabilities that weak and insolvent clients implicitly shift onto these reserves. Indeed, an overvalued fund tends to intensify moral hazard by leading depositors and com- peting institutions to ignore evidence of individual bank insolvencies. Even if left unfunded, a country's deposit insur- ance scheme could still be given immediate access to a credit line from the national treasury or from reinsurance contracts written with reliable outside insurers. Irrespective of whether net deposit losses are funded ex ante or ex post, it must be made clear that funds to cover losses will come principally from surviving banks. Otherwise, government backup threat- ens to reduce market discipline and increase fragility. Evidence also shows that involving private parties in managing deposit-insurance arrangements reduces moral hazard and fragility. While private managers can also shirk their duties and even misappropriate funds, stakeholders in any private scheme have strong incentives to monitor managerial actions. Source: Demirgüç-Kunt and Kane 2002. branch or subsidiary in normal situations as well as idation will take place in response to the heightened in times of systemic crisis; (5) handling consolidated competition, at least in some segments of banking. supervision in a market that depends heavily on for- Across the world, the effects of consolidation for eign banks; (6) effectively exchanging information banking sector stability have been somewhat mixed. with the home supervisors in the case of bank hold- On the one hand, consolidation can augment the ing companies or other complex financial institu- size, market power, and profits of banks, enhance tions; (7) dealing with increasing concentration in diversification, and create greater incentives for the banking system by foreign banks; and (8) im- secure banks to avoid imprudent risk-taking. On the proving the governance structure of complex inter- other hand, politically connected banks may be- national banking groups while, among other things, come more leveraged and take on greater risk, know- enhancing the integrity standards in the financial ing they can rely on policymakers to help when adverse markets. As noted above, consolidated supervision shocks hurt their solvency or profitability. Similarly, and information exchange among supervisors (in- large, politically influential banks may shape the cluding with host-country supervisors) are areas policies and regulations affecting banks in general. that need strengthening in East Asia. Cross-country empirical work has found that larger It may well be that as banking in the region be- banks take on more risks than smaller banks (though comes more contestable, greater market-led consol- for higher returns) (see, for example, de Nicolo and 94 East Asian TABLE 4.5 Aspects of Deposit Insurance Schemes in East Asia Finance Hong Kong Features Indonesia Korea Malaysia Philippines Thailand (China) Singapore Date established Law enacted in 1995 Deposit insurance 1963 Draft law of 2006 Consultative paper 2004; blanket scheme introduced December 2004 on draft insurance guarantee in September 2005 awaiting parliamen- bill January 2005 phased out tary approval beginning July 2005 Compulsory or not? Yes Yes Yes Yes Yes Yes Yes Public/private Public Public Public/private Public Public Public Public management Sources of deposit Insurance Insurance premiums; Insurance premiums Insurance premiums, Insurance premiums Insurance premiums Insurance premiums premiums issuance of securities bank borrowings, issuance of securities Supervisory function No No Yes, as required by Yes No No No Bank Negara Malaysia Institutions covered Banks Banks, securities Banks, (including Universal and Banks Banks Banks and finance companies.; insur- subsidiaries of foreign commercial banks; companies ance companies; banks in Malaysia); rural banks, mutual, savings and Islamic banks; finance specialized finance companies; companies government banks credit unions Annual premium Risk-based: 0.1­0.3 percent de- 0.5 percent 0.2 percent Risk-based. 0.1­0.6 percent pending on type of 0.05 percent for institution lowest-risk banks- 0.14 percent for highest-risk banks Coverage amount Rp 100 million Won 20 million RM 60,000 PHP 250,000 Baht 50 million for first HK$100,000 S$20,000 per depositor, (US$11,200) (US$48,000) (US$ 15,790) (US$4,600) year (US$1.3 million); (US$12,800) (US$12,100) per institutiona reduced to Baht 1 million by 4th year a. Calculated at 2004 average exchange rates. Fostering an Efficient and Sound Banking Sector 95 others 2003). Also, higher concentration in a bank- customer due diligence (know your customer, mon- ing system appears to be associated with higher lev- itor business relationships, practice enhanced vigi- els of systemic risk. This heightens the importance lance toward high-risk customers), (2) keep records, of prudential regulations and requirements as well (3) report suspicious transactions, and (4) institute as of ongoing supervision. internal controls. Compliance with these standards affects the efficiency of transactions and raises the Combating money laundering cost of doing business. With progressively greater financial integration, As noted earlier, the region is relatively weak in fighting money laundering is likely to become a the implementation of BCP 15, which sets out key more complex challenge. As the region liberalizes its criteria on measures for the banking sector to take financial sector and undergoes rapid financial and against money laundering and terrorist financing. economic transformation it also needs to put in Many countries worldwide have the essential legal place policies to prevent the abuse of an increasing elements of an AML-CFT regime in place, but a re- array of financial institutions that have a significant cent review shows considerable weakness in com- cross-border dimension. Financial deepening and pliance in the financial sector.72 In countries in East diversification provide more avenues for criminals Asia, where AML-CFT systems are quite sophisti- and money launderers to abuse bank and non-bank cated, effectiveness in implementation is impaired financial institutions such as exchange bureaus, wire by poor coordination among government agencies. remittance services, insurers, brokers, and traders. Further, lack of skills, training, and resources often The relative openness of the region's financial sector hinder the capacity of supervisory authorities to and economic structure, and the fact that two of the investigate and ensure compliance with AML re- world's major financial centers are in the region, quirements (for customer due diligence and sus- makes it even more important for financial institu- picious transactions reports) and limit the capacity tions in East Asia to meet international regulations of law-enforcement authorities to prosecute cases. Finally, international cooperation and information against money laundering and the financing of ter- exchange--either among administrative authorities rorism (AML-CFT), so its diverse investment and or through mutual legal assistance channels--is im- trade transactions can be effected in the most effi- proving but needs further strengthening. cient and lowest-cost way possible. Financial institutions in East Asia are increas- Overall, in recent years, countries in the region ingly adopting risk-based frameworks that accord have made significant progress in their AML-CFT flexibility and allow measures to be commensurate policies and in their capacity to implement them. with the risk of money laundering and financing of They are fully cognizant of their vulnerabilities and terrorism. Using a risk-based approach in the regu- the very serious negative consequences these might latory framework for AML-CFT is consistent with have for the integrity and stability of their financial the shift toward risk-based supervisory regimes that systems, and they have taken significant steps toward would enable these countries to meet the new Basel compliance with international standards on AML- II standards (see below). The challenge to the region CFT. Several of them have enhanced their AML-CFT lies in strengthening the supervisory skills needed to legal frameworks, set up new institutions (in particu- assess vulnerabilities and identify risks, so that sanc- lar, financial intelligence units), developed AML-CFT tions and oversight are appropriate and proportion- supervisory frameworks for financial institutions, and ate to these risks. improved coordination between financial regulatory authorities and law-enforcement agencies. Through a Adopting the Basel II Capital Adequacy web of bilateral memoranda, the region has improved Framework: some supervisory challenges its capacity to participate in international cooperation. The region is also leading the initiative within the On June 2004, central bank governors and the heads Financial Action Task Force on Money Laundering of bank supervisory authorities in the G-10 countries (FATF) to use AML-CFT as another instrument to adopted a new capital adequacy framework com- combat corruption (Box 4.10). monly known as Basel II and primarily intended for For financial institutions, the FATF recommen- internationally active banks among the G-10 coun- dations define four key requirements: (1) undertake tries (Table 4.6).73 96 East Asian Finance BOX 4.10 Combating Money Laundering and Financing of Terrorism Money laundering involves disguising funds obtained from criminal activities and investing them in activities that may or may not be criminal. Financing terrorism concerns mainly the use of funds to support terrorism-related activities re- gardless of the origin of these funds. As the methods used to channel funds for terrorist purposes are the same as those used by money launderers, AML/CFT systems use a common infrastructure. In addition to broader macroeconomic considerations (such as distorting prices and competition, and increasing the volatility of capital flows and exchange rates) money laundering can compromise bank soundness. Economic damage can arise not only from direct financial system abuse but also by seriously harming the reputation and integrity of coun- tries' financial institutions and by undermining investors' trust in those institutions. Trust underpins the existence and development of financial markets, and the efficient functioning of financial markets depends heavily on the expectation that high professional, legal, and ethical standards will be observed and enforced by financial sector regulators, for both banks and non-bank financial institutions. In 1990, the Financial Action Task Force on Money Laundering (FATF) issued a set of 40 recommendations that pro- vided a comprehensive plan of action needed to fight money laundering. In 2001, FATF issued eight special recommen- dations on Combating the Financing of Terrorism. Since then FATF has significantly revised the 40 recommendations and issued a revised methodology and a ninth special recommendation on terrorist financing. The recommendations (FATF+9) cover all the measures that national AML/CFT regimes should incorporate within their legal, criminal justice, and regulatory systems. An effective AML-CMT system requires an adequate legal and institutional framework and law-enforcement mechanisms, as outlined in the FATF recommendations. The AML-CFT system should include (1) laws that define money-laundering and terrorist-financing offenses and provide for freezing, seizing, and confiscating the proceeds of crime and terrorist funding; (2) laws, regulations, or in certain circumstances, other enforceable means that impose the required obligations on financial institutions and on designated non-financial businesses and professions; (3) an appropriate institutional or administrative framework that provides competent authorities with the necessary duties, powers, and sanctions; and (4) laws and other measures that give a country the ability to provide the widest range of international cooperation. In addition, the Basel Committee on Banking Supervision, the International Association of Insurance Supervisors, and the International Organization of Securities Commissioners have each incorporated broad supervisory standards and guidelines against money laundering and the financing of terrorism, as part of the standards that their respective in- dustry players are required to observe. These standards are consistent with the FATF+9 recommendations. The Basel Committee has issued three documents covering anti-money-laundering issues: · Statement on Prevention of Criminal Use of the Banking System for the Purpose of Money Laundering. This essentially covers four principles that should be used by banking institutions: (1) proper customer identification; (2) high ethical standards and compliance with laws and regulations; (3) cooperation with law enforcement authorities; and (4) poli- cies and procedures to be used to adhere to the statement. · Core Principles for Banking Supervision. BCP 15 deals with money laundering by stipulating that bank supervisors must determine that banks have in place adequate policies and procedures, including strict know-your-customer (KYC) rules. · Customer Due Diligence for Banks. This document provides extensive guidance on appropriate standards for banks to use in identifying their customers. It was issued in response to a number of deficiencies noted on a global basis with regard to the KYC procedures. In addition, the standards go beyond the fight against money laundering and are in- tended to help protect banks' safety and soundness more broadly. Source: World Bank and IMF 2005. Most jurisdictions in East Asia have signaled that ments of Basel II build on and go beyond the BCPs. they intend to partially or fully adopt Basel II in the Indeed, while the motivation for Basel II is to better medium term.74 Assessed at the end of 2004, banks' align capital with risks and allow banks to manage preparedness for Basel II in the region appeared to their risks in the long term, not only banks but reg- vary widely, but had increased significantly over the ulators and supervisors are likely to face major chal- preceding two years. Effective implementation of lenges during the transition. the original Basel Core Principles is really a pre- Because Basel II has been developed largely with requisite for moving to Basel II, given that the ele- reference to the experience of G-10 countries, it im- Fostering an Efficient and Sound Banking Sector 97 TABLE 4.6 Main Features and Key Requirements for the Different Approaches Under Basel II Pillar 1: Capital adequacy Main features Key requirements Credit risk 1 Limited increase in risk sensitivity compared to Basel I Simplified Standardized (more risk buckets and risk weights for sovereigns Approach (SSA) and banks based on risk scores provided by recog- nized export-credit agencies). Operational risk charge: 15 percent of annual gross income. Pillars 2 and 3 applicable. Credit risk 2 More risk buckets than SSA and increased risk Ratings of external credit assessment Standardized Approach (SA) sensitivity. agencies. Risk weights for asset classes based on ratings of ex- Ability and capacity to qualify rating ternal credit-assessment agencies or export-credit agencies and map agency scores. agency scores. Enhanced credit risk mitigation available. Credit risk 3 Based on risk components: probability of default, Ability to assess banks' rating system Foundation Internal Ratings- loss given default, and maturity. design. based Approach (F-IRB) Banks can use own estimates of probability of default Ability to validate banks' risk-manage- and supervisory estimates for other components. ment and stress-testing systems. Comprehensive risk-management requirements (rating Ability to provide supervisory estimates system design, internal control environment, etc.). of loss, given default and exposure at Stress testing required. default. Credit risk 4 Capital requirements determined as in F-IRB. Ability to assess banks' rating-system Advanced Internal Ratings- Banks can use own estimates for probability of default, design. based Approach (A-IRB) loss given default, exposure at default, and matu- Ability to validate banks' risk-manage- rity, subject to supervisory validation of systems. ment and stress-testing systems. Comprehensive risk-management requirements (rating system design, internal control environment, etc.). Stress testing required. Operational risk 1 Flat rate of 15 percent of average gross annual income. Basic Indicator Approach (BIA) Operational risk 2 Operational risk charges for each business line, based System to distinguish business lines and Standardized Approach (TSA) on average annual income per business line, multi- supervisory ability for validation of plied by risk factor per business line. this system. Data on operational risk Comprehensive risk management requirements. occurrences and cost. Operational risk 3 Full reliance on banks' internal risk-measurement sys- Capacity for supervisory validation. Advanced Measurement tems, subject to supervisory approval. Approach (AMA) Comprehensive risk-management requirements. Pillar 2: Supervisory review process Main features Key requirements Banks have an internal capital-adequacy assessment Supervisory ability and capacity to make process and a strategy for maintaining capital level. the necessary assessments. Supervisors evaluate banks' internal capital-adequacy Adequate legal and regulatory framework systems, their outcomes, and banks' risk profiles. to take action. Supervisors can require higher capital-adequacy levels for their banking system or for individual banks, where appropriate. Early intervention by supervisors. Stress tests and assessment of interest rate risk and concentration risk. (Continued) 98 East Asian Finance TABLE 4.6 Main Features and Key Requirements for the Different Approaches Under Basel II (Continued) Pillar 3: Market discipline Main features Key requirements Information to be disclosed includes: Banks' information systems to produce · Available capital in the group, capital structure, de- required breakdowns. tailed capital requirements for credit, market, and Accounting and auditing systems that operational risks; safeguard accuracy of disclosures. · Breakdown of asset classification and provisioning; Supervisor's ability to require disclosure, · Breakdown of portfolios according to risk buckets monitor, and verify. and risk components; · Credit-risk mitigation methods and exposure cov- ered by these methods; · Operational risk; · Market risks. plicitly assumes that a proper banking environment in risk-based supervision and in the management of is in place. Countries' degree of compliance with credit- and operational risks, as well as information- the BCPs can provide an indication of the extent to technology systems. Supervisors in the region are which this is the case. For instance, special attention already planning to offer training on Basel II issues should be paid to the following issues: to nearly 3,500 members of their staff. Implementing Basel II will also be a major test of A well developed public infrastructure needs to supervisors' independence. Indeed, supervisors are be in place (for example, an environment that likely to face strong pressure from some banks to fosters the honoring and enforcement of finan- move to Basel II or to be allowed to use the advanced cial contracts). approaches, and they will also need to deal with po- Banks must be able to implement strong internal tential conflicts of interest related to their increased control systems. A widespread credit-risk culture involvement in banks' risk-management processes. and sound risk-management practices within the Some East Asian supervisors have in the past allowed banking sector are also essential. weak banks to classify assets more leniently than Accounting standards used for financial state- prudence would suggest, and thereby enabled these ments must be reliable. banks to defer the recognition of losses. Such behav- Supervisory authorities must have adequate re- ior would undoubtedly compromise the integrity of sources and independence to fulfill their mission. the Basel II process by distorting its outcomes in Consolidated supervision must be carried out.75 terms of capital requirements and altering its incen- Efficient cross-border cooperation between su- tives in terms of risk management. pervisors must be in place, especially to be able to Below is a brief review of issues likely to arise in address the numerous home-host issues related implementing the component parts of Basel II in the to Basel II. region. Pillar 1: capital adequacy. The standardized ap- Basel II is not a one size-fits-all regime either for proach to credit risk is expected to be the preferred banks or for countries. Many of the Pillar 1 provi- approach of most banks in the East Asia region. This sions are open to national discretion, while Pillar 2 is mostly a refinement of the existing Basel I frame- only sets out broad principles, thereby leaving super- work coupled with the introduction of a direct rela- visors a good deal of leeway in its implementation. tionship between risk weights and the ratings of Most countries will need to adapt the framework to recognized external credit-rating agencies. take into account domestic features. This will re- Among the major issues that need to be consid- quire considerable planning and training for super- ered before implementing this approach are those visors, with a likely increased demand for expertise related to the recognition of external credit-rating Fostering an Efficient and Sound Banking Sector 99 agencies and to the risk weights to be applied for the ing them, or because bank consolidations have af- retail portfolio. fected the consistency of historical information. With regard to retail assets, capital requirements Pillar 2: supervisory review process. Pillar 2 re- could decrease significantly, with risk weights re- quires all Basel II banks, including those imple- duced from 50 percent to 35 percent for residential menting only the standardized approaches, to have mortgages and from 100 percent to 75 percent for an internal process for assessing capital adequacy. A other types of retail exposures. These provisions survey by Ernst & Young (2005) suggests that at the should only be implemented with sufficient caution end of 2004 about half the banks in the region were because: at very early stages of implementing Pillar 2, and that 25 percent had not yet started work on it. Some jurisdictions (including Malaysia and the Supervisors will need to monitor and review a Philippines) have experienced significant losses bank's internal rating systems. In this regard, stress on residential mortgages in the past; testing is an extremely important mechanism for a Commercial real-estate lending has frequently bank to be able to allocate sufficient capital over the led to significant losses in the region; and economic cycle. Supervisors will also need to be at- The 75 percent risk weight for credit cards seems tuned to risks that are not captured directly in Pillar I low for many East Asian markets, given the se- ratios (including credit-concentration risk, interest- vere losses that some, notably Korea, have expe- rate risk in the banking book, and business-cycle ef- rienced frequently after a rapid build-up of their fects). Where regulators have concerns that a bank's exposures. underlying risks are not properly addressed or re- flected in regulatory ratios, they should exercise their Korea's experience with credit-card debt illus- authority to require overall risk-based capital above trates that: the Basel II regulatory minimum of 8 percent.76 Upward adjustments to Basel II weights may in Generally speaking, Pillar 2 intends to make su- some cases be justified; pervisory practices more transparent--which in Basel II alone may not be able to address stability turn will promote the legitimacy and credibility of issues such as rapid changes in portfolio structures. supervisors from the perspective of the institutions that they supervise. Beyond Basel II, it is thus essential that supervi- Pillar 3: market discipline. The third Pillar of Basel sors monitor trends in banking risks and intervene II establishes rigorous standards for a bank's disclo- where appropriate. sure of its risk profile and capital, in order to leverage For countries seeking to apply the internal ratings- the ability of market participants to monitor banks based (IRB) approaches, the design of rating systems and prevent them from taking undue risks. The min- and the quality of data are clearly key issues, which in imum Pillar 3 disclosure requirements cover the many cases will be difficult to solve in the short term. bank's capital structure and key pieces of information Few banks have yet developed and integrated risk- that go into the calculation of its Basel II risk expo- grading systems into their daily processes, but Basel sure. Pillar 3 also sets forth standards for qualitative II requires banks applying IRB to have used rating disclosures that help explain a bank's risk measures. systems roughly in line with the IRB minimum Pillar 3 requires disclosure that goes far beyond requirements for at least three years. Data required current practices in East Asian banks. Its implemen- to implement IRB models are often unavailable, tation will greatly enhance the transparency of banks' whether because banks have only just started collect- risk profiles. Deepening the 5 Securities Markets The main challenge in The development of the securities markets has been a primary goal of East Asia's financial policymakers since the crisis. Sizable further developing the progress has been made: equity market capitalization has almost securities markets is to tripled for the region as a whole, and the value of bonds out- enhance their liquidity standing has almost quadrupled, since 1997. But significant chal- lenges remain. This chapter reviews the progress made to date, and efficiency. analyzes the key issues of access and efficiency in the equity and bond markets, and concludes with the main policy challenges that need to be addressed to further develop these markets. Developments in East Asian Securities Markets Since the Financial Crisis Equity markets--as measured by stock market capitalization-- have grown significantly since 1997, although they have yet to recover to pre-crisis levels in Malaysia and Thailand.77 In the region as a whole, the market has almost tripled since the crisis (Table 5.1). While stock markets in the region are still considerably smaller than in the United States, United Kingdom, or Germany (and in aggregate still account for only 6 percent of world stock-market capitalization), in relation to the size of domestic economies they compare favorably to the markets of advanced industrial coun- tries. Indeed, stock market capitalization as a percentage of GDP is actually larger in Hong Kong (China), Singapore, or Malaysia than in the United States, the United Kingdom, or Germany. Starting from a much smaller base, bond markets have grown even more rapidly over the past few years (Table 5.2). In most of the countries in the region, much of the initial impetus to this growth came from bonds issued by governments, largely to restructure banking systems following the crisis. At this point, several important questions arise, which are dis- cussed in what follows: First, how broadly accessible are the securities markets in the region for firms seeking to raise funds and for investors seek- ing to invest? 101 102 East Asian Finance TABLE 5.1 Size of Equity Markets (Market Capitalization) 1997 2004 Economy/region US$ billions % of GDP US$ billions % of GDP China 101.4 11.2 447.7 23.1 Indonesia 29.1 12.2 73.3 28.8 Rep. of Korea 41.9 8.1 389.5 57.1 Malaysia 93.2 93.8 181.6 153.3 Philippines 31.2 37.7 28.6 33.0 Thailand 22.8 15.1 115.4 71.4 Hong Kong (China) 413.3 234.4 861.5 519.5 Singapore 106.3 110.8 217.6 202.3 East Asia region 839.1 n.a. 2,315.1 n.a. Memorandum: Japan 2,160.6 50.2 3,557.7 76.2 Germany 825.2 39.1 2,865.2 44.0 United Kingdom 1,996.2 150.4 1,194.5 133.8 United States 10,730.6 130.1 16,323.5 139.9 Bolivia 0.3 4.1 1.3 16.3 Greece 34.2 28.2 121.9 61.6 Lithuania 1.7 17.2 3.5 19.3 Mexico 157.0 39.1 122.5 19.6 Turkey 61.1 32.3 68.4 28.4 Ukraine 3.7 7.3 4.3 8.7 Sources: WFE, World Bank staff calculations. Note: n.a. = not applicable. Second, how liquid and efficient are they? Effi- two-way interaction between the size of securities cient markets allow the prices of securities to re- markets and their liquidity: not only do larger flect their economic fundamentals, and to adjust markets tend to be more liquid, but more liquid quickly and accurately to new material informa- markets tend to attract more investors and firms. tion. Efficiency is key from the perspective of ex- Third, in light of the above, what are the policy ercising governance over firms and of allocating priorities in further developing the securities resources appropriately. Moreover, there is a markets in the region? TABLE 5.2 Size of Bond Markets (Domestic Bonds Outstanding) 1997 2004 Economy/region US$ billions % of GDP US$ billions % of GDP China 116.4 12.9 483.3 24.9 Indonesia 4.5 1.9 57.7 22.7 Rep. of Korea 130.3 25.1 568.3 83.2 Malaysia 57.0 57.0 106.6 90.0 Philippines 18.5 22.3 25.0 28.8 Thailand 10.7 7.1 66.5 41.1 Hong Kong (China) 45.8 25.9 76.8 46.3 Singapore 23.7 24.7 78.6 73.1 EA region 401.2 n.a. 1,461.2 n.a. Japan 4,433.6 97.6 8,866.7 197.7 Germany 1,739.7 44.5 2,225.7 81.2 United Kingdom 777.7 23.5 1,040.8 48.8 United States 12,656.9 62.9 19,186.6 161.6 Sources: ADB Asian Bonds Online and World Bank staff calculations. Note: n.a. = not applicable. Deepening the Securities Markets 103 Access to securities markets was only US$38 million, of which only US$18 mil- lion came from IPOs (Table 5.3). How important are stock markets in the region from The number of firms listed on stock exchanges is the perspective of firms? While it is difficult to obtain relatively small, particularly in Thailand, Indonesia, a full picture, indicators suggest that the role of equity and the Philippines (Figure 5.1). markets varies significantly across the region--with In some East Asian countries much of the stock those in Hong Kong (China), Republic of Korea, market is accounted for by a relatively few large firms. Malaysia, and Singapore playing an important role, and those in Indonesia, the Philippines, and to a Standard concentration ratios--the proportion of lesser extent Thailand, having the potential to play stock market capitalization or trading accounted for a much more important role than they do now. by, say, a country's top ten firms--vary worldwide East Asia compares very favorably to other devel- (those in the US and Canada are among the lowest), oping regions such as Latin America and Emerging but they appear to be especially high in the Philippines Europe in the amounts of capital raised through and Indonesia. The Herfindhal index (Table 5.3) initial public offerings (IPOs). At end-2004, almost points to the same finding.79 US$32 billion was raised in East Asian primary mar- In a few countries in the region, a sizable propor- kets (contributing to a total of US$66.6 billion in eq- tion of shares remains inaccessible to cross-border uity). This compares to US$4.6 billion raised on the investors. As of end-2004, foreign investors did not primary markets in Emerging Europe and US$0.66 have access to 42 percent of the stock market in the billion on those in Latin America.78 However, the Philippines, 41 percent in China,80 and 36 percent in amount of equity raised in 2004 in the Philippines Thailand (Figure 5.2).81 TABLE 5.3 Indicators of Access to Stock Markets for Firms Top 10 concentration Top 10 ratio concentration Equity raised (US$ billions) (in market ratio Herfindhal capitalization) (in trading) Economy Primary Secondary Total index Percent Percent China 4.3 3.6 7.9 0.0142 19.9 13.4 Indonesia 0.2 0.5 0.7 0.1011 71.2 57.4 Rep. of Korea 11.0 3.9 14.9 0.0513 18.0 24.4 Malaysia 0.9 1.1 1.9 0.0207 36.5 17.3 Philippines 0.0 0.0 0.0 0.1249 79.4 90.6 Thailand 1.0 1.3 2.3 0.0493 54.7 51.4 Hong Kong (China) 12.5 23.7 36.1 0.0464 49.5 30.2 Singapore 2.1 0.7 2.8 0.0484 58.5 23.9 Memorandum: Japan 0.3 31.1 31.3 0.0125 27.6 19.8 Germany 0.0 2.5 2.5 0.0487 58.7 37.0 United Kingdom 13.8 18.7 32.5 0.2158 61.3 35.9 Canada 12.2 20.6 32.8 0.0159 28.1 25.6 United States (NYSE) 70.3 93.4 163.7 0.0034 12.6 17 Chile 0.3 0.9 1.20 0.0551 55.5 84.9 Greece 0.2 1.6 1.8 0.2280 93.3 29.1 Mexico 0.2 0.8 1.0 0.0581 63.6 90.4 Peru 0.0 0.2 0.2 0.1040 86.3 86.1 Spain 2.6 5.2 7.8 0.0648 68.1 83.3 Turkey 1.7 0.8 2.5 0.0460 52.6 56.2 Source: WFE, World Bank Financial Sector Development Indicators (FSDI). Notes: The Herfindhal index measures the statistical distribution of the market value of stocks outside the top ten firms. It is defined as the sum of squares of the market shares of each individual firm and ranges from 0 (competitive or equally distributed) to 1 (monopolistic or dominated by one firm). 104 East Asian Finance FIGURE 5.1 Number of Listed Firms a. Number of listed firms, 2004 b. Number of listed firms 6,000 25 5,000 20 people 4,000 15 Hong Kong, China 10,000 3,000 Singapore per 10 2,000 firms 5 Malaysia 1,000 listed Rep. of Korea Indonesia 0 0 ysia an tes 0 20 40 60 80 China Korea China apore Jap Sta Indonesiaof . Mala Thailand Kingdom per capita GDP, thousands Philippines Sing Reo Kong, United United Hong Source: World Bank Financial Sector Development Indicators (FSDI). In East Asian bond markets, limited access to except Hong Kong, China and Korea) has been on finance by corporations is an issue across a broad range account of bonds issued by governments. Although of countries. As mentioned earlier, much of the growth in several countries the corporate bond market has in bond markets (more than 50 percent of the growth accounted for a reasonable proportion of the growth, during 1997­2004 in all economies in the region in most countries it remains quite small as a propor- tion of total bonds outstanding (Table 5.4). Indeed, even in Malaysia and Korea--where the FIGURE 5.2 Proportion of Shares That Are Inaccessible bond market is much better diversified among gov- to Foreigners, 2004 ernment, corporate, and financial institutions than in the region on average--the issuers of bonds are 50 concentrated at the high end of the credit-quality spectrum. In Malaysia, about 40 percent of the mar- 40 ket comes from issuers with local ratings of triple A and another 40 percent from issuers with double A ratings. In Korea, some 80 percent of the bonds issued tnecr 30 are single A or above. pe The fact that most of the bond markets in the region 20 are dominated by high-quality borrowers is evident from the large proportion of quasi-government 10 issuance. For instance, although the issuers repre- sented in the HSBC Local-Currency Index82 include 0 non-government issuers, the latter are all quasi- ina sia sia nes government institutions. Quasi-government issuers Ch lay ailand Indone p. of KoreaMa Philippi Th are likely to borrow with government guarantees, Re whether explicit or implicit. Hence they are likely to Source: World Bank, FSDI. obtain the highest-quality credit available domesti- cally (Jiang and McCauley 2004). TABLE 5.4 Breakdown by Type of Bond Issuer 1997 (% of GDP) 2004 (% of GDP) Contribution to growth 1997­2004 (%) Economy Government Corporate Financial institutions Government Corporate Financial institutions Government Corporate Financial institutions China 7.5 0.7 4.7 14.8 0.6 9.5 60.7 -0.3 39.3 Indonesia 0.4 0.8 0.7 20.1 1.5 1.1 94.6 3.1 2.3 Rep. of Korea 4.9 10.3 10.0 25.2 23.3 34.9 34.9 22.3 42.8 Malaysia 19.4 20.8 16.8 38.2 38.0 13.9 56.7 52.0 -8.8 Philippines 22.3 0.1 0.0 28.7 0.1 0.0 100.3 -0.3 0.0 Thailand 0.2 6.0 0.9 22.4 12.3 6.4 65.2 18.6 16.2 Hong Kong (China) 7.4 18.5 0.0 9.5 36.8 0.0 10.3 89.7 0.0 Singapore 13.6 11.2 0.0 41.2 32.4 0.0 56.6 43.4 0.0 Sources: ADB, BIS, and country sources. Deepening the Securities Markets 105 106 East Asian Finance In bond markets as in equity markets, the number extent, in Malaysia (Table 5.5). In the Philippines, of corporate foreign issuers is still small, at zero percent the turnover ratio is as low as 14 percent--only one of total corporate bond issuance in China; 0.1 percent sixtieth of NASDAQ, the most actively traded secu- in Korea; 0.2 percent in Indonesia, the Philippines, rities market in the world. and Thailand; and 0.4 percent in Malaysia. Only in Liquidity, or its lack, will be reflected in, and af- Hong Kong (China) and Singapore--the two finan- fected by, the availability of information with which cial centers--is the proportion of foreign issuers high, to price securities accurately, by transaction costs, at 36 percent of total corporate issues in Singapore and by the size and heterogeneity of the investor base and 56 percent in Hong Kong (China). (a diversity of investors with different risk appetites makes a divergence of views more likely and fosters trading). Liquidity and efficiency Poor information disclosure affects the efficiency Limited liquidity83 in the securities markets is a key of a market directly, because if information disclosure challenge facing most countries in the region. An illiq- is poor, prices will not reflect fundamentals. It also uid market will not be efficient because new informa- affects efficiency indirectly, through liquidity, because tion cannot be promptly reflected in transactions. a market with poor information is likely to exhibit Moreover, the contribution that stock markets make higher price volatility and discourage trading and to economic growth is through liquidity. price discovery. Transaction costs comprise both the explicit Equity markets costs of trading--such as commissions, settlement Low liquidity in equity markets is a particular prob- fees, and taxes--and the implicit costs, which rep- lem in Indonesia and the Philippines, and to some resent the opportunity costs of delaying or not ex- TABLE 5.5 Liquidity in Equity Markets, 2004 Economy Turnover ratio Ratio of value traded to GDP China 87.0 45.4 Indonesia 44.9 10.7 Rep. of Korea 147.2 94.0 Malaysia 33.8 50.8 Philippines 14.3 4.2 Thailand 110.8 66.7 Hong Kong (China) 57.7 269.3 Singapore 60.8 76.1 Memorandum: Japan 97.1 74.2 Canada 66.2 66.7 France 65.5 Germany 133.8 51.8 United Kingdom 116.6 173.2 United States NASDAQ 249.5 NYSE 89.8 165.9 Bolivia 0.3 0.1 Georgia 12.9 0.5 Greece 37.5 21.4 Lithuania 9.3 2.1 Mexico 29.1 6.3 Turkey 176.9 48.8 Sources: World Bank FSDI and WDI. Notes: The table shows two standard measures of liquidity in the equity markets--the turnover ratio (or the value of stock trading relative to the size of the market), and the ratio of value traded to GDP (or the value of stock trading relative to the size of the economy). These two measures can give substantially different impressions of liquidity: for example, a small but liquid market will have a high turnover but low value traded relative to the size of the economy. Another major difference is that the value traded embodies a price effect: value traded can increase, without a rise in the number of transactions or a fall in transactions costs, if there is an increase in the price of shares traded. The turnover ratio is not affected in this manner because prices enter both the numerator and denominator. Deepening the Securities Markets 107 ecuting a trade. A market with high transaction are not providing much firm-specific information; costs will see less trading and have fewer price move- as noted, in an efficient market, stock prices should ments in response to relevant news and therefore reflect information about firms' fundamentals, be less liquid and less efficient. Trading costs and hence the returns on individual stocks should are quite high in the equity markets of most coun- not be highly correlated with the returns on the tries in the region, particularly in the Philippines market portfolio as a whole.86 (Table 5.6). Korea, Hong Kong (China), Malaysia, and Singa- The implicit costs of trading are of course difficult pore have the most efficient markets in the region-- to measure. One approach, which in effect captures although Korea ranks in the third-highest quartile and both explicit and implicit transaction costs, is to mea- the remainder rank only in the median range of a sure the number of zero-return day trading days, con- global sample of 85 economies. In the bottom quartile trolling for general market conditions. Securities or are Thailand, Indonesia, the Philippines, and China. securities markets with high transaction costs will have In general, East Asia's securities markets are rel- less frequent price movements, and more zero-return atively stable compared with those of other regions. days, than securities with low transaction costs.84 (High volatility and instability of the equity markets Figure 5.3 shows a measure of efficiency that can also discourage trading and affect liquidity and captures both transaction costs and the quality of efficiency.) Figure 5.4 shows a composite indicator information disclosure.85 The composite index com- that captures two dimensions of stability: volatility, bines an index of the zero-return or stale-trading measured by the standard deviation of stock market days, to represent transaction costs, and an index returns over three years, and the skewness of returns, of stock market synchronicity (that is, co-movement which measures the extent to which markets are more among individual stock returns), to represent the likely to deliver large negative returns.87 quality of information disclosure. High synchronic- Among a sample of 100 economies worldwide, ity indicates that the returns on individual stocks Singapore falls in the highest (most stable) quar- TABLE 5.6 Trading Costs in Equity Markets Economy Price Commissions Fees Market impact Total averages (US$) (basis points) (basis points) (basis points) (basis points) Indonesia 0.3 47.7 10.6 9.9 68.1 Rep. of Korea 34.3 29.3 12.4 19.2 60.9 Malaysia 1.6 34.2 6.1 15.7 55.9 Philippines 0.4 48.5 34.4 11.3 94.1 Thailand 1.0 43.7 1.8 11.4 56.9 Hong Kong (China) 1.5 22.3 10.7 11.3 44.3 Singapore 3.1 25.7 2.0 13.8 14.5 Memorandum: Japan 14.7 12.9 0.3 6.3 19.5 Canada 17.5 20.3 0.2 6.5 27.0 France 31.0 17.9 0.4 7.7 36.0 Germany 33.8 17.6 0.6 14.1 32.3 United Kingdom Buys 5.3 14.2 49.8 7.4 71.4 Sells 5.2 13.4 0.8 13.3 27.5 United States (NYSE) 25.0 18.2 0.3 7.8 26.3 Chile 0.7 29.1 10.2 15.7 55.0 Greece 12.9 28.7 19.2 10.9 58.8 Mexico 2.1 26.3 0.1 8.2 34.6 Peru 3.3 20.5 0.5 25.2 46.2 Spain 14.1 17.5 0.5 11.8 29.7 Turkey 0.0 31.4 2.7 20.6 54.7 Source: Elkins McSherry trading costs 2004. 108 East Asian Finance FIGURE 5.3 Equity Market Efficiency Composite measure of efficiency of equity markets 8 Mexico United States 6 United Chile Russian e Spain Kingdom Rep. of Hong Kong, Federation orcs Korea China Malaysia Turkey dezidrad Singapore 4 Japan Thailand Indonesia an st Philippines 2 China 0 Source: World Bank, FSDI. Note: The composite index shown combines an index of the zero-return or stale-trading days, to represent transaction costs, and an index of stock market synchronicity (that is, co-movement among individual stock returns), to represent the quality of information disclosure, as explained in the text. tile, followed by Hong Kong (China) and Malay- make it more likely that an equity market will be sia in the second-highest quartile. Indonesia, the unstable and deliver large negative returns. Hence, Philippines, and Thailand fall in the bottom quar- continued improvements in disclosure should tile, as does Korea. Cross-country analysis suggests help to make the region's equity markets more that inadequate disclosure of information can stable. FIGURE 5.4 Equity Market Stability Composite measure of stability of equity markets 8 Singapore 6 Hong Kong, e China Malaysia orcs China Philippines Indonesia dezidrad Thailand Rep. of 4 Korea an st 2 0 Source: World Bank FSDI. Note: The stability indicator is a composite indicator, based on measures of volatility and the skewness of returns--that is, the extent to which markets are more likely to deliver large negative returns. Deepening the Securities Markets 109 Bond markets liquidity for them to sell and exit easily when needed. And, if liquidity is limited and price discovery does Lack of liquidity is an even greater problem in East not function well, the investors that do participate Asia's bond markets than in its equity markets. The will generally demand a higher interest rate or return region'sbondmarketsoverallaremuchlessliquidthan to compensate for the low liquidity, and this, in turn, those of advanced industrial countries (Table 5.7).88 may further deter companies from listing on the stock And, not surprisingly, liquidity is even more limited exchange or issuing bonds. Thus, as discussed in the in the corporate bond market. Corporate bonds are first part of this section, to enhance the efficiency of generally much smaller than government bonds, East Asian securities markets, policymakers will need and this contributes to illiquidity. Moreover, because to address the factors that affect liquidity. they vary in coupon rates and maturity, bonds issued They will also need to encourage the develop- by the same issuer may not be substitutable. ment of more diverse instruments to address the needs of both investors and issuers. As noted in Deepening the Securities Markets Chapter 4, most countries in the region allow banks to conduct investment banking and brokerage In East Asia the key reason for the small corporate business. In a competitive environment, this could bond markets is the lack of liquidity in secondary mar- encourage banks to speed their development of such kets. A lack of liquidity in secondary markets matters instruments, contributing to the development of not only for efficiency but also for the overall size of the securities markets while improving their own the market, because there is a two-way interaction profitability. Further, the adoption of Basel II could between the size of the primary market and liquid- make banks more interested in providing such instru- ity in the secondary market. Investors are generally ments to economize on their capital, rather than willing to invest in securities only if there is enough just extending loans or warehousing them. And TABLE 5.7 Liquidity in Bond Markets Turnover ratio (percent) ABF2 Bid-ask spreada Value traded (US$ billions) government (basis points) and quasi- Economy Government Corporate Government Corporate sovereign Government China 568.6 1.4 2.2 12.0 55.2 n.a. Indonesia 27.7 0.9 0.6 0.2 102.0 14.3 Rep. of Korea 952.2 382.2 3.3 1.0 610.4 2.5 Malaysia 84.3 38.1 1.8 0.8 135.6 4.3 Philippines n.a. n.a. n.a. n.a. 33.9 n.a. Thailand 70.1 5.6 2.0 0.3 228.7 6.3 Hong Kong 542.4 n.a. 34.7 n.a. 623.1 2.4 (China) Singapore 130.5 n.a. 3.2 n.a. 535.5 3.2 Japan 29,964.2 1,139.6 5.4 0.9 n.a. 2.0 Canada 6,428 n.a. 30.6 n.a. n.a. 0.7 Germany 6,600 n.a. 10.1 n.a. n.a. 0.2 United 6,516 n.a. 14.2 n.a. n.a. 0.5 Kingdom United States 103,829 n.a. 37.9 n.a. n.a. 0.4 Sources: Value traded, turnover ratios, and bid-ask spreads for Asian economies from ADB Asian Bonds Online and Newsletter 2004. ABF2 turnover ratio from International Index Company, September 2005. For OECD countries, value traded and turnover ratios from Debt Management and Government Securities Markets, and bid-ask spreads from ADB Newsletter 2004, except for Canada and Germany which are as of 2006 from World Bank FSDI. Notes: n.a. = not applicable. a. The bid-ask spread generally provides a good indication of liquidity if the outstanding bond issuance is large and if there are an adequate number of well- capitalized bond dealers. It may be a less accurate measure of liquidity for some of the markets in East Asia. In general, given that the majority of bonds are traded over the counter, trading data are difficult to obtain and hard to compare across countries. 110 East Asian Finance for smaller corporations, mechanisms such as secu- ficiency in securities markets. Based on accurate ritization can enhance access to securities markets. and timely flows of information, liquidity can be generated by the activity of investors who disagree about fundamentals, facilitating the process of Improving the liquidity and efficiency price discovery. As discussed above, the continued of securities markets strengthening of corporate governance and disclo- The liquidity in secondary markets and, ultimately, sure will be fundamental to the further develop- the efficiency of securities markets overall, is affected ment of the securities markets. by the three factors that were noted above: the size For bond markets, several other infrastructural and the diversity of the investor base, the availability components need attention to facilitate accurate of timely and relevant information for investors to pricing. accurately price securities, and the transactions costs Benchmarking. First, there is the need to be able involved in trading. The shaded ovals in Figure 5.5 to price corporate bonds off a "risk-free" benchmark indicate important areas that could benefit from (or index interest rate). The most common bench- further strengthening. mark is the interest rate of a government bond. To be a valid comparator, the price of a government bond Improving information to price securities accurately must be truly driven by supply and demand. For this The availability of accurate and timely informa- to happen in China, for instance, the authorities tion for investors is a key element in ensuring ef- would need to move away from price-controlled FIGURE 5.5 Factors Affecting the Efficiency of Securities Markets EFFICIENCY OF SECURITIES MARKETS C variety of Liquidity investor bases A B information to transaction price accurately costs (explicit-- taxes, commission, fees--and implicit) For bonds: · benchmarks · credit rating · PDs, intermediaries Corporate governance Market infrastructure Complementary & mechanisms infrastructure · shareholder rights · repo markets · creditor rights trading forms · securities lending · disclosure standards & practice pre-settlement · margin trading including · accounting and auditing ­ trade confirmation T+1 or less short selling clearance and settlement · derivatives markets ­ central counterparty ­ real time gross settlement or netting ­ CSD ­ dematerialized ­ final settlement by T+3 ­ DVP Source: Author. Note: shaded ovals indicate important areas that could benefit from further strengthening. Deepening the Securities Markets 111 auctions. The benchmark bond issues must also be frequencies and whether an issue is "out-of-market" liquid,89 and issues of benchmark bonds must be or not.91 appropriately spaced along the maturity spectrum Second, governments can use re-opening and to enable investors to accurately price instruments buyback operations as ways to increase the fungi- whose maturity is somewhere between the benchmark bility of benchmark issues. Re-opening--issuing the rates. Ideally, there should be liquid benchmark same bond with the same maturity and coupon on bond lines at key points along the yield curve, for more than one occasion--reduces the need to open example at one year, two years, five years, and ten years a different issue and gradually builds up the out- (although the precise maturities may vary according standing volume to the desired benchmark level. to individual markets), and each benchmark maturity Re-opening benchmark lines, however, makes it more should have a volume of bonds on issue that is suf- likely that issuance will be into a benchmark with an ficiently large, relative to the market's total size and the "out-of-market" coupon, which may be less desirable market's average transaction size. Once established, for investors. Buybacks--repurchasing government the length of a yield curve should be maintained by bonds before they mature--can be used in conjunc- issuing a new long-dated line as appropriate. For tion with re-openings to eliminate bonds that are example, if the length of the yield curve is around not being actively traded.92 ten years, a new ten- to eleven-year maturity should Third, an issuer can act in the secondary market be issued in time for its liquidity to be built up before to improve the liquidity of the benchmark yield curve. the term to maturity of the existing ten-year bench- Thus policymakers may facilitate switches by dealers mark shortens too much. who are seeking to trade in more liquid issues, reduc- East Asian economies have attempted to build ing problems relating to the fragmentation of issues. benchmark yield curves in government bonds since In China, for instance, instead of opening a new bond 1998. Hong Kong (China) and, even more so, Sin- at every issue, tranches or slices of existing bonds gapore, have succeeded in developing both short could be issued instead at key maturities (three, five, and intermediate yield curves (for up to 15 years). In ten, fifteen, and twenty years), thereby building up Korea, Malaysia, and Thailand, liquidity is limited large liquid bond issues that bond holders could more in issues with maturities of more than five years. In easily sell in the secondary market. China's Ministry Korea, whose government does not issue short-term of Finance could, moreover, examine the scope for treasury bills, a short-term benchmark is missing. switching from existing bonds into the new bench- While Indonesia has made progress in introducing mark issues, in order to increase the amount out- government benchmarks, the bond market is still standing in each benchmark issue. The Philippines young, and will likely take some time to produce a has recently announced a consolidation program true market yield curve. Finally, while the Philippines in which holders of two- to seven-year Philippine has a yield curve for sovereign bonds, in practice the Treasury bonds are invited to exchange them for an market is very illiquid and most of the trading takes inaugural series of domestic benchmark bonds. place in bonds with maturities of less than one year. Fourth, the interest of intermediaries and investors China has no benchmark yield curve yet. in a market, and hence market liquidity, is likely to Although ultimately the market decides whether be enhanced when the government's general strategy an issue is to be treated as a benchmark, governments as an issuer is known and when changes in that strat- have a variety of ways to help develop such issues.90 egy are communicated in a timely fashion. Clearly it The first of these is to consolidate and standardize would not be advisable to announce all issuance the government's own issues. While having a variety details well in advance, because this would reduce the of debt instruments is beneficial, so as to cater to the government's flexibility in responding to changing preferences of different investors, too much variety market conditions and the corresponding changes can fragment the market. Fragmentation hinders in the preferences of intermediaries and investors. substitutability among bonds, reduces the size and But pre-announcing an intent to issue bonds allows trading of benchmark issues, and disperses market market participants to formulate their strategies and liquidity over many issues. Many forms of fragmen- construct their portfolios, and thus is likely to increase tation can arise from the existence of different bonds, market interest in the bonds. The information com- including coupon rates, maturities, issue sizes, and municated to the market may include an indicative 112 East Asian Finance issuance schedule, target issuance volumes for bond perform effectively, they need to be well capitalized, maturities, and intervals between benchmark lines. to be staffed with professionals experienced in fixed- Fifth, in general, there is an absence of market income and risk-management products, and to prac- makers to foster liquidity in the bond markets in the tice good governance. region. The establishment of a primary-dealer system The primary-dealer systems in Hong Kong (China) for government securities can help to foster liquidity and Singapore function well. Korea's system is frag- in a market for government bonds and thus also help mented as there are two sets of dealers: well-capitalized to establish a benchmark yield curve. Many coun- financial institutions that are used by the Bank of tries use such systems. The advantage of having a Korea to conduct monetary operations, and a larger dedicated group of market makers is that, in return group of dealers that auction government securities for certain privileges (such as exclusive rights or and participate in secondary markets. Malaysia has advantages in bidding at auctions, exclusive access recently taken steps to improve the functioning of its to blind inter-dealer screens), they can ensure the primary-dealer system (Box 5.1). In Indonesia and success of the auctions in the primary market and Thailand, primary dealers are not required to give promote liquidity in the secondary market by provid- two-way quotes, and this somewhat reduces their ing two-way quotes. For primary-dealer systems to impact in enhancing liquidity. BOX 5.1 Measures to Enhance Liquidity in the Domestic Bond Market in Malaysia In January 2005, Bank Negara Malaysia (BNM) announced several important measures to foster the development of a more liquid secondary market to facilitate the price-discovery process: · The active use of repurchase agreements (repos) as a monetary policy instrument; · The introduction of the Institutional Securities Custodian Program (ISCAP) to enable the borrowing and lending of securities; and · Securities lending facility for principal dealers. Use of repurchase agreements To further develop the repo market, BNM has started using repo operations as one of its monetary policy instruments to manage liquidity in the banking system. Its repo operations seek to (1) encourage market participants to actively use repos as an alternative funding instrument; (2) enhance the flexibility for market participants to use these securities in managing settlement risks and trading strategies; and (3) further strengthen the banking industry's risk-management capabilities by encouraging banks to move toward collateralized inter-bank transactions. Borrowing and lending securities via ISCAP ISCAP is a web-based custodian system developed by BNM to encourage the participation of institutional investors in securities lending. Through ISCAP, BNM will borrow securities from major institutional investors such as pension funds and insurance companies. The borrowed securities, mainly Malaysian Government Securities (MGS), will be used by BNM for its repo operations. By "freeing" the captive holdings of MGS by institutional investors to market participants, the overall liquidity in the bond market will be further enhanced. Securities lending facility for principal dealers A securities lending facility for the ten principal dealers has been introduced to facilitate market-making activities and pro- mote competitive pricing. This will enhance the ability of principal dealers to provide and quote continuous prices for MGS, improve the price-discovery process, and add to liquidity in the secondary market. The securities for this lending facility will be sourced from ISCAP or from BNM's own holdings. Since a sufficient supply of MGS is crucial for a successful securities lending facility and repo operations, BNM may also purchase MGS from primary and secondary markets based on market prices. To ensure that these purchases do not influence or distort market prices, the purchase of MGS at primary tenders will be based on the weighted average price of the tender and limited to a maximum of 10 percent of the issue size. The amount purchased in the secondary market will be limited to 10 percent of the outstanding amount issued. Source: Bank Negara Malaysia, "Measures to Further Enhance Liquidity in the Domestic Bond Market." Press release, January 7, 2005. Deepening the Securities Markets 113 Generally in the region, the obligations and priv- Trade reporting. Third, although more controver- ileges of primary-dealer systems need to be further sial (since immediate disclosure could reduce the clarified. There is also a need to buttress the priv- liquidity available for large trades), evidence suggests ileges of these systems to include funding through, that post-trade transparency encourages competitive for example, repurchase agreements (repos). As dis- pricing and helps to make markets more liquid.96 In cussed below, in several countries the repo mar- the United States, for example, trading in corporate kets remain underdeveloped--posing an additional bonds was quite limited, but since 2002, dealers in challenge. corporate bonds have been required to report over- Finally, it is important that primary-dealer sys- the-counter trades to the Trade Reporting and Com- tems be well capitalized. In China, for instance, to pliance Engine (TRACE) of the National Association prevent firms from taking unduly large risk posi- of Securities Dealers (NASD). TRACE then publicly tions relative to capital in the purchase agreement, disseminates the trade data. Such transparency has in securities borrowing and lending, and in deriv- reduced bid-ask spreads by an average of five basis atives markets, it has been recommended that the points (Edwards and others 2005). People's Bank of China and the China Securities Reg- In recent years, some East Asian countries have ulatory Commission (CSRC) (1) require brokers started to enact reporting requirements similar to and dealers in government bonds to meet capital those of TRACE, but they have largely limited these requirements that are related to each firm's net assets requirements to dealers. Malaysia has the Bond and contingent liabilities (for example, agreements Information Dissemination System (BIDS), which to repurchase securities that have been used as collat- requires dealers to record price and volume infor- eral for repos); (2) ensure that the requisite capital mation into the system within ten minutes of a requirements are met at all times and that appro- trade, and makes summary information available priate electronic record-keeping systems are devel- to the public with a ten-minute delay. In Thailand, oped, installed, and used by brokers, dealers, and the Thai Bond Market Association requires traders institutional investors to track positions and capital; to report over-the-counter trades within 30 minutes and (3) ensure that all participants in the market are and distributes the trade information to Associa- able to review the financial status of participants tion members four times a day. In Korea, the Korea with whom they want to trade.93 Security Dealers' Association requires dealers to Rating agencies. A second important element for report their transactions within 15 minutes, to be the pricing of bonds is the existence of good rating disseminated to the public on a website on the agencies. Rating agencies play a very important role same day.97,98 in helping to determine the credit risk and thus the Some countries have also moved to provide in- spread pricing of corporate bonds. Local rating agen- vestors with better access to information and to fa- cies exist in all countries covered in this report94 and cilitate trading by encouraging it to take place on their penetration in the domestic markets is relatively high. However, several of them are relatively new and trading platforms (although the majority of both need more time to build a track record.95 Moreover, government and corporate bonds in most of the although several joint ventures have been formed countries are traded over the counter). Korea, for between international and domestic rating agencies example, has an elaborate electronic trading plat- (such as between PEFINDO and Standard and Poor's form that could be used for trading Asian bonds in Indonesia), large discrepancies in the rating stan- at the regional level. The Internet-based trading dards across countries in the region have been doc- system of the new Korea Exchange is available to umented in the past. In any event, rating agencies in bond traders in Korea, but it has not been very the region still do not accept the ratings made by popular thus far, as most bond traders still prefer their counterparts in other countries of the region. over-the-counter trading. Indonesia's Surabaya And, while the major international rating agencies do Stock Exchange also provides an electronic trading rate corporations in East Asia, they generally do not platform. Thailand has launched a Bond Electronic provide ratings across the full array of bond issuers Exchange, whose experience to date has not been in individual countries. Clearly this can hamper cross- very encouraging (Box 5.2); the Thai government border investments. is now considering creating an inter-dealer trading 114 East Asian Finance BOX 5.2 Trading Fixed-Income Instruments on the Exchange in Thailand The Bond Electronic Exchange (BEX) was established in November 2003 as a division of the Thai Stock Exchange to pro- vide investors with additional investment instruments. In May 2005, BEX acquired a bond-trading platform that had been developed by the Thai Bond Dealers' Club. In addition to providing better access to information, BEX expects to make it easier for bond investors to trade bonds. BEX is expected to create a more efficient and liquid secondary bond market, since prior to BEX, bonds were traded over the counter, mainly by institutional investors, and small investors were unable to get into this market. BEX currently uses the trade-by-price method. However, the committed price will be converted into an indicative yield to assist investors in their investment decisions. Although only publicly listed companies are currently allowed to trade on BEX, non-listed companies will soon be able to have their bonds traded there. The process is as follows: Automatic matching order An investor can place an order through a member of the Exchange or a brokerage company, who, in turn, enters the order into BEX's trading platform. As in equity trading on the Thai Stock Exchange, the orders are sequenced using the first in- first out (FIFO) algorithm. FIFO follows the sequence of price and then time priority. If the bid or offer price and volume can be matched, the orders are matched automatically. Put through When the trading value exceeds 10,000 units--roughly equivalent to 10 million baht (US$250,000)--an alternative method provided by the BEX called the "put through" must be used. The counterparties can negotiate off the Exchange. Once the deal is concluded, the seller can initiate the put-through transaction, which then needs to be verified by the buyer. Once the confirmation process is complete, the buyer will allow the transaction to go to the next phase in the process: clearing and settlement. Clearing and settlement Thailand Securities Company, Limited, known as TSD, administers the process of clearing and settlement. Currently it takes two working days to complete the clearing and settlement once an order has been executed. Experience to date BEX is still at an introductory stage and almost all bond transactions continue to be conducted in the over-the-counter market. Retail investors have shown little interest in it thus far. Source: Bond Electronic Exchange, Thailand. system that will provide market participants with opportunity costs (costs that may be incurred if the transparent market information but allow them to execution of an order is delayed or if the trade is not trade over the counter in some form. The Philippines executed). has recently set up an exchange to facilitate inter- Both market infrastructure and supporting infra- dealer trading in fixed-income securities. structure can affect transaction costs. In its market infrastructure the region is well placed, with almost all Reducing transactions costs jurisdictions having fairly advanced clearing and set- High transaction costs deter investors from trading tlement systems with recommended features to min- and can exacerbate problems of efficiency. As dis- imize the various risks associated with pre-settlement cussed above, transaction costs cover the explicit and settlement of securities (Table 5.8). costs of trading and the implicit costs of execution This is borne out by the GSCS benchmark clear- that exist because orders may, as a result of their ance and settlements ratings and the Thomas Murray size and/or the scarcity of counterpart orders on the post-settlement scores for countries in the region market, execute at high prices (if they are buy orders) (Table 5.9). or low prices (if they are sell orders). Specifically, such However, East Asian countries vary widely in their execution costs comprise bid-ask spreads, market supporting infrastructure--that is to say, in the devel- impact (an adverse change in price that occurs when opment of repo markets, securities lending, margin an investor tries to trade in a large volume), and trading, and derivatives (Box 5.3). Deepening the Securities Markets 115 TABLE 5.8 Where Countries Stand on Elements Affecting Pre-Settlement and Settlement Risks Hong Kong Risk Control China Indonesia Korea Malaysia Philippines Thailand (China) Singapore Pre-settlement risk Trade confirmation B+ A­ A A B+ A­ A A (T=0) Settlement cycles (T+3 or less) stocks T+3 T+3 T+1 T+1 T+3 T+2 T+1 T+1 bonds T+3 T+3 T+1 T+1 T+1 T+1 T+1 T+1 Central counterparty No No No No No No No No Settlement risk Central Securities Y Y Y Y Y Y Y Y Depository (CSD) Delivery vs. payment Y Y Y Y Y Y Y Y Timing of settlement Y Y Y Y Y Y Y Y finality CSD risk controls n.a. Y Y Y Y Y Y Y Cash-settlement assets Y n.a. Y Y Y Y Y Y Operational risk Y Y Y Y Y Y Y Y Custody risk Y Y Y Y Y Y Y Y Source: International Organization of Securities Commissions. Notes: Ratings follow standard Alpha scale from AAA (highest) to C. Y = Yes. n.a. = not applicable. The lack of these instruments and facilities reduces both short and long positions (or margin purchases liquidity and increases the transaction costs of trad- and short selling).99 The argument for allowing mar- ing (Table 5.10). gin trading is to introduce liquidity to the system. Perhaps the most debated of these elements is An argument against margin trading is that it can margin trading--leveraged trading with respect to fuel feedback trading and thus destabilize the market. TABLE 5.9 Scores on Clearance and Settlement Infrastructure and Post-Settlement Economy GSCS benchmark clearance and settlement score Post-settlement score China 92.5 A- Indonesia 68.5 A Rep. of Korea 97.3 A+ Malaysia 93.3 A+ Philippines 92.4 A Thailand 93.6 A Hong Kong (China) n.a. A+ Singapore n.a. AA- Memorandum: Greece 85.0 A+ Japan n.a. A+ Mexico 90.5 A+ Peru 97.8 A- Turkey 98.3 A Venezuela, R.B. de 72.6 BBB Sources: GSCS Benchmark and Thomas Murray. Notes: GSCS compares the settlement efficiency of markets, incorporating average trade size, local market interest rates, the proportion of trades that fail, and the length of time for which they fail. Thomas Murray produces ratings of post-trade risk exposures according to various criteria of clearing and settle- ment, safekeeping, and asset servicing. The ratings follow a standard alpha scale from AAA to C. n.a. = not applicable. 116 East Asian Finance BOX 5.3 Repos and Securities Lending Repos. Under a repurchase agreement (repo), a party agrees to sell securities to another against the transfer of cash, with a simultaneous agreement to purchase the same securities (or equivalent securities) at a specific price on an agreed date in the future. Repo transactions are carried out to transfer particular securities between counterparties or to facilitate col- lateralized cash loans or funding transactions. Most bond lending and bond financing is carried out through repo trans- actions. Outside the United States, there is also a growing market in repos for equity. Securities lending. This describes the market practice by which, for a fee, securities are transferred temporarily from one party (the lender) to another (the borrower) who is obligated to return them either on demand or at the end of an agreed period. Securities lending provides liquidity to money, bond, and equity markets. The increase in liquidity reduces trad- ing costs and thereby increases market efficiency. Securities lending enables market participants, especially dealers, to sell securities that they do not own, knowing that they can borrow prior to settlement. The ability to borrow and lend securities relatively freely enables securities broker-dealers to service a broad range of their clients including asset man- agers, hedge funds, and other broker-dealers. There are several motivations for borrowers, including to cover short sales either as a stand-alone transaction or as part of a larger trading strategy such as convertible bond arbitrage, pair trading, or merger arbitrage. On the lending side, securities lending has become an important and growing part of revenues for institutional investors (pension funds, insurance companies, and other plan sponsors), custodian banks, and the prime brokerage arms of major investment banks. A further argument is that margin trading, especially mental value, reducing liquidity in a declining market short selling, can make the market too susceptible to and delaying the market recovery. In fact, systemic manipulation; in particular, a short seller's loss when risk in a market without short sales but with margin short-squeezed can be unlimited, while a margin pur- purchases is exacerbated by the fact that an asym- chaser's losses will be limited to his initial exposure. metrical price-adjustment process takes place, in Thus short selling poses potential systemic risks.100 which stocks cannot be profited upon even if they Often, therefore, countries prohibit short selling. decline in value.101 Even if short selling is not explicitly prohibited, the Even if all margin trading is prohibited, with the lack of an efficient borrowing and lending system goal of ensuring symmetry, it is harder to enforce a for stocks makes short sales impractical for both restriction on margin purchases than on short sales, financial and operational reasons. As shown in since it is hard to tell whether the funds used for Table 5.10, China and Malaysia currently prohibit purchasing a particular stock were borrowed or not, short selling--although Malaysia has recently an- given that money is fungible. In contrast, restrictions nounced a partial lifting of the ban in short sales on short selling are easier to enforce, since to borrow that was imposed at the time of the crisis. In several securities systematically for short selling requires a other countries, short selling is allowed but is not stock-lending system to be formally established and practiced, given shortcomings in the securities lend- efficiently operated. Thus, when margin trading is ing and repo markets. prohibited, a country may in practice end up with Nonetheless, market symmetry--in terms of an asymmetrical situation, in which margin purchases allowing both margin purchases and margin sales-- are taking place. is important for liquidity: in a leveraged and sym- Arguably it may be better for countries to consider metrical market, a trader can efficiently buy or sell at allowing both margin purchases and short sales and minimal and uniformly applicable costs immediately ensuring that the requisite elements for margin trad- in response to new market information. Asymmet- ing within reasonable bounds of safety are in place. rical market liquidity--in which securities invest- These elements comprise margin accounts, margin ments can be financially leveraged through margin lending, and stock lending, discussed in turn below. lending but short sales are prohibited--can lead to At the same time, in addition to a viable regulatory long-run deviations of stock prices from their funda- framework, the operation of these elements requires TABLE 5.10 Key Factors Affecting Liquidity and Efficiency of Securities Markets Hong Kong Issue China Indonesia Korea Malaysia Philippines Thailand (China) Singapore Information and price discovery Information 4.8 4.0 5.8 6.0 5.0 5.3 6.7 7.4 disclosure and corporate governance Benchmark yields None. True yield curve Limited liquidity in Limited liquidity Has a sovereign Limited liquidity in Successful in Successful in short yet to emerge. issues with ma- in issues with yield curve issues with ma- short and and intermediate turity of over maturity of but in practice turity of over intermediate yield curves. five years. over five years. very illiquid. five years. yield curves. Most trading with maturity of less than one year. Credit-rating services Needs Needs Needs Needs strengthening. strengthening. strengthening. strengthening Information Bond pricing dissemination company exists Primary dealers (PDs) Yes. No obligation to Two sets of dealers. PDs required to Fixing banks re- No obligation to PDs required to PDs required to make markets. PDs required to make 2-way quired to pro- make two way make 2-way make 2-way make 2-way quotes on vide bids on quotes. quotes on all quotes on quotes on on- T- bills, Bank benchmark T- Exchange all government Deepening the-run Negara bills and fixed Fund notes. securities. Krungthai Bank Malaysia notes, treasury notes. issues. Max bid- and on-the-run offer 10 basis Malaysian the points. Government Securities securities. (continued) Markets 117 118 East Asian TABLE 5.10 Key Factors Affecting Liquidity and Efficiency of Securities Markets (Continued) Finance Hong Kong Issue China Indonesia Korea Malaysia Philippines Thailand (China) Singapore Transaction costs Withholding taxes CGT: 5% WHT CGT: 20% WHT on CGT: The lower of CGT: None. CGT: None for CGT: 15%. No CGT CGT: None. CGT: None. WHT on on interest interest income. 11% of gross WHT on inter- transactions on government WHT on interest income: income: Other tax: 0.1% sales proceeds est income: on the ex- bonds or certain interest None for govern- 10% for QFII. of gross sale or 27.5% of net None. change. WHT quasi-govern- income: ment and certain proceeds is capital gains. on interest in- ment bonds. None. quasi-government withheld by the WHT on interest come: 20%. WHT on interest bonds. broker as in- income: 27.5% income: None come tax for for government securities trans- or government- actions exe- guaranteed debt; cuted on the 15% otherwise. exchange. Repo markets Planned in 2007a Underdeveloped, Underdeveloped Relatively devel- Underdeveloped Underdeveloped Mature repo Mature repo market Available for so dealers un- but available oped but available but available market government able to short with tenors from Available with with tenors with maturities bonds 7 days overnight to maturities up overnight, 14 up to 6 months. to 1 year. 90 days. to 1 year. and 30 days. Margin purchases · margin purchases Nob Yes Yes Yes Yes Yes Yes Yes allowed? · margin loans No b Yes Yes Yes Yes Yes Yes Yes allowed? · margin purchases No Yes Yes Yes Yes Yes Yes Yes practiced? Short sales · short sales allowed? Nob Yes Yes Noc Yes Yes Yes Yes · stock lending allowed? Nob Yes Yes No No Yes Yes Yes · short sales practiced? No No Yes No No No Yes Yes Notes: The figures in the disclosure and corporate governance cells are the overall corporate-governance-culture scores from Credit Lyonnais Securities Asia and thus represent market views on the overall level of corporate governance. CGT = capital gains tax. WHT = withholding tax. QFII = qualified foreign institutional investors. a. Repo markets in China are available for government bonds but not enterprise bonds. b. The new amendments to the securities law in China leave open the possibility of margin trading but do not specify purchases or sales. c. Malaysia has just announced a partial lifting of the ban on short sales that was imposed during the crisis. Short selling will be limited, however, to fewer than 100 stocks out of the nearly 1,000 listed. Deepening the Securities Markets 119 that the regulator; the intermediaries, including credit pension funds). A stock-lending system must be suppliers; and investors have keen awareness and efficient and robust, not only to facilitate short sales good risk-management skills. but also to prevent abnormal short squeezes. Wide Margin accounts. Investors conduct margin trading participation by stock lenders in a stock-lending sys- in a margin account opened by their stockbrokers. tem will reduce the risk of a short squeeze by making The responsibilities of the stockbroker include ex- it easier and less expensive to cover short positions. plaining the risks of margin trading to the investor. Since stock lending and borrowing expose the trans- The regulator, stock exchanges, or the stockbrokers' acting parties to each other's credit risk and to the self-regulatory organization also need to set rules and market risk of loaned securities, they can potentially regulations specific to trading in a margin account lead to systemic risk, due to the leveraged nature of and to enforce them. Trading in a margin account is the short sales that underlie stock loans. The legal, usually subject to margin requirements.102 Margin regulatory, and supervisory framework of stock lend- requirements are set separately for the initial margin, ing must be comprehensive and coherent so that in order to start margin trading, and for the mainte- participants in the system can comply with relevant nance margin, to continue trading, with the former rules and regulations and manage risks properly. being higher. The higher the margin requirement, There is often a tradeoff between the efficiency and the less leveraged the investor and the less risky the robustness of the system, and finding the right bal- investment. The appropriate margin requirement ance is important. may vary across countries and over time, depending Since the stock borrower pledges collateral with on many factors including market liquidity, market the lender and the borrower's collateral is marked to volatility, market-price level, mark-to-market fre- market daily and subject to margin calls, stock lending quency, and trade-settlement efficiency. poses a new challenge to the regulator in terms of col- Margin lending. In a well-defined regulatory frame- lateral management. The regulator needs to address work, stockbrokers and banks should be allowed to at least two aspects of risk management. The first provide an investor with a loan facility secured by relates to the variety of risks--credit, interest, price, shares, bonds, and/or cash, so that the investor can liquidity, operational, and legal--that the stock lender purchase and refinance margin-eligible securities. may face, depending on what sort of securities are Margin lending is normally regulated by the margin- made eligible for collateral. Regulators need to ensure account regulations that govern both margin pur- that stock lenders have the necessary risk-management chases and short sales. processes in place. The second pertains to the scope Margin lending increases trade size as well as of participants in the stock-lending market. If stock volumes, and hence the settlement amounts. Thus lenders--individuals and institutions--are under dif- the smooth running of a margin-lending facility where ferent supervisory jurisdictions, the coherence and daily rolling settlement occurs requires a deeper coordination of risk-management regulation applic- money market than otherwise. Trades must be settled able to different categories of stock lenders could be on a daily basis, thus resulting in a smaller netting a challenge. effect on settlement amounts. A margin purchase It is important to note that though the components locks up money until the margin purchaser closes of short selling have some standard features, their his position. Therefore margin purchases, especially design and operation will need to be country- or in a booming market, may reduce the liquidity of market-specific, reflecting the existing financial struc- the money market, and so a deep money market is ture and market infrastructure and the current com- essential. The regulator must supervise the compliance position of the investing community. For instance, of stockbrokers' margin-lending facilities with mar- the level of development and openness of money ket regulations through on- and off-site inspections. markets dictate the design of margin-lending facilities. Stock lending system. Short selling requires a lend- Whether institutional investors or retail investors ing system to be in place for stocks or securities in dominate will be of importance in the design of a order for short sellers to borrow shorted stocks.103 In securities-lending system. Also, the characteristics addition to stock brokers, lenders of stocks can be and composition of factors affecting the design are securities depositories, custodial banks, investment likely to change over time, so components will need managers, and institutional investors (insurance and to be modified accordingly. 120 East Asian Finance Broadening the investor base tries, covers aspects of securities laws related to self- dealing (that is, the expropriation of investors by The investor base in most countries in the region is managers or controlling shareholders) (Djankov and quite small, and tends to be dominated by govern- others 2005). That study found that what matters ment-controlled provident funds, insurance com- most for market development are those aspects of the panies, and banks. Such investors tend to buy and law on self-dealing that favor private over public hold. Institutional investors who might trade more monitoring and enforcement.106 actively, such as fixed-income funds and hedge funds, The securities laws of most countries in the re- are typically absent from these markets or are only gion cover these aspects relatively well (Table 5.11), allowed very limited credit exposures. Foreign in- although Indonesia lacks some elements of the dis- vestors, too, are missing from some of these markets closure requirements, Thailand lacks several elements (Gyntelberg and others 2006). Even where markets of the liability standards, and the Philippines ranks are not closed to them, foreign investors are often low on the anti-self-dealing standards. discouraged from participating by taxes and by a lack of markets for hedging instruments such as currency swaps, particularly in the bond markets.104 Improving access to finance There is thus a need to further diversify the do- for smaller corporations mestic institutional and retail investor base, as well Countries in the region also need to encourage a as the asset-management industry. The latter is dis- growing and more diverse set of issuers of securities-- cussed further in Chapter 6. Measures to strengthen both in size and credit quality--to appeal to institu- and broaden the investor base will need to include tional and retail investors. opening up and facilitating cross-border investment Several factors affect the interest of firms in seeking from both within and outside the region. financing from securities markets. These include the From the perspective of investors generally, a legal costs of listing, access to other long-term funding, and and regulatory framework that promotes good cor- disclosure requirements. The costs of listing include porate governance is essential. This includes well- the management fees that are paid for the advice in defined rights that can protect outside shareholders structuring the transaction, preparing the documen- from the actions of controlling shareholders and man- tation for credit-rating agencies, and issuing registra- agers,105 the adoption and enforcement of bankruptcy tion and other documentation, as well as underwriting laws that clearly define creditors' rights and borrow- costs; legal fees; fees to obtain credit ratings, in the ers' responsibilities, and timely and accurate public case of bonds; and taxes. disclosure of financial information. Issues of share- Issuance costs and processes can vary significantly. holder and creditor rights and information disclosure, Some countries in the region may have room to reduce which are important for the development of financial some of these costs, although generally the under- markets more generally, were discussed in Chapter 3. writing business in the region appears to be quite As discussed in that chapter, the region now fares competitive and has already resulted in a compres- quite well in terms of many of the legal and reg- sion of fees charged by lead managers. ulatory elements of corporate governance--the Some of these costs--particularly legal fees and main challenge now lies in their implementation and credit-rating fees--are subject to economies of scale, enforcement. in that they may fall with the frequency and size of Empirical work has found that aspects of securities issue, making stock market listing more difficult for laws related to disclosure and private monitoring smaller firms. are important for the development of the securities One way to facilitate access to external, non-bank markets. One cross-country analysis, using data for financing by smaller companies is to have different 49 countries across the world, has established a boards or market tiers on an exchange (or to have significant correlation between stock market devel- several exchanges) that compete by having different opment and the extent of disclosure and private listing criteria that can facilitate access to capital for monitoring that is specified in the law regarding smaller enterprises. Over the last decade, many new prospectuses for public offerings (La Porta and others markets have been established globally, trying to 2006). Another study, based on a sample of 72 coun- replicate the success of NASDAQ, which was set up Deepening the Securities Markets 121 TABLE 5.11 Ratings of Securities Laws on Disclosure Requirements, Liability Standards, and Anti-Self-Dealing Disclosure Liability standards Anti-self-dealing Economy Legal origin requirements index index standards index China n.a. n.a. n.a. 0.78 Indonesia French 0.50 0.66 0.68 Rep. of Korea German 0.75 0.66 0.46 Malaysia English 0.92 0.66 0.95 Philippines French 0.83 1.00 0.24 Thailand English 0.92 0.22 0.85 Hong Kong (China) English 0.92 0.66 0.96 Singapore English 1.00 0.66 1.00 Memorandum: Japan German 0.75 0.66 0.48 Canada English 0.92 1.00 0.65 Germany German 0.42 0.00 0.28 United Kingdom English 0.83 0.66 0.93 United States English 1.00 0.66 0.65 Chile French 0.58 0.33 0.63 Greece French 0.33 0.50 0.23 Mexico French 0.58 0.11 0.18 Peru French 0.33 0.66 0.41 Spain French 0.50 0.66 0.37 Turkey French 0.50 0.22 0.43 Sources: La Porta and others 2006, Djankov and others 2005. Notes: Thailand has a French-derived civil law with other influences. Indonesia has a Dutch civil law derived from German civil law, also with other more recent influences. However, La Porta and others classify securities laws into three major categories: English, French, and German: English denotes all common-law systems; French includes derivatives such as Spanish; and German includes derivatives such as Scandinavian and Dutch. n.a. = not available. to cater to new and high-growth corporations. The trading-record requirement, no requirement of prior track record of these new exchanges has been mixed. shareholder approval for transactions, and no min- Although they have followed broadly similar strate- imum capital requirement. However, the company gies, differences in focus and context have affected must appoint a nominated adviser ("nomad") who the outcomes of their efforts. For example, the Neuer is responsible, among other things, for warranting to Markt in Germany, which focused narrowly on high- the LSE that the company is appropriate for AIM. The tech companies, failed in part because of this narrow company's application for admission is pre-vetted focus, the lack of sophistication of both investors by the nomad, and not LSE. and regulators, and bad timing, since it was launched A few such specialized markets exist in East Asia: just as the stock market bubble was beginning to the Growth Enterprise Market in Hong Kong (China), deflate.107 SESDAQ and SEDAQ in Singapore, KOSDAQ in The Alternative Investment Market (AIM) pro- Korea, and MESDAQ in Malaysia.108 moted by the London Stock Exchange (LSE) was The experience of different alternative-market launched in 1995 to cater to the needs of small, grow- models suggests some general observations: markets ing companies, and applies a less stringent regulatory that focus too narrowly on one sector are vulnerable regime than that of the main LSE. In the context of the to a downturn in that sector; a market that targets strong investment culture and regulatory capacity relatively unsophisticated investors needs to be more that prevails in the United Kingdom, AIM has created stringently regulated109; and a supervisory and advi- a light-touch regulatory environment that sets out to sory role, similar to that played by the nomads in attract a broad set of companies from different sectors AIM, can be useful. and focuses on the needs of institutional investors. In addition to alternative exchanges, countries have For a company to list on AIM, there is no minimum looked to alternative instruments and mechanisms. level of shares required to be held by the public, no For instance, Mexico has created a specialized com- 122 East Asian Finance pany category tailored to bridging the gap between markets, including the implications of corporatizing unlisted small- and medium-size enterprises and stock exchanges and the adoption of a disclosure- listed companies, in which institutional investors are based system for regulating the primary offering of permitted to invest (Box 5.4). securities, and assesses the key elements of the regula- Securitization can be an important means for tory framework for securities markets in the region. smaller companies to access securities markets, as discussed in Chapter 7. However, loans to small bus- Demutualization inesses may not be easily securitized into large homogeneous pools that credit agencies and investors One of the recent trends seen internationally-- can easily analyze, given factors such as the hetero- and increasingly in East Asia as well--is a move to geneity of the individual loans, and differences among demutualize stock exchanges (Box 5.5). Demutu- the underwriting standards of the originators. Thus alization is seen as a means to address problems if the markets for securitized loans to small busi- of languishing domestic securities markets, fierce nesses are to grow, the underwriting standards and international competition, and the need to upgrade documentation for these loans must be made more the infrastructure of an exchange through invest- uniform, and information for estimating the risk of ments in technology. loss must be made more easily available. Conversion from a not-for-profit organization Venture capital is a potential source of capital for controlled by brokers or the government to a for- issuers. Generally some regulation is needed to make profit company with a broader shareholder base venture capitalists willing to invest in firms that are can help a stock exchange to cope better with the little known and have not yet established a reputation. challenges arising from greater global competition. Also important for such investors is an exit mecha- Demutualization can also help to raise the funds nism (typically an initial public offering [IPO]), needed for investments in technology, and provides since venture-capital investments generally do not a more attractive vehicle for professional managers. pay dividends but yield their returns through the And it can facilitate the development of links and capital gains obtained upon exit.110 alliances between exchanges, whether by permitting one exchange to invest in another, or through cross- shareholdings between exchanges. Strengthening the Regulatory So far, five out of the eight countries covered Framework for Securities Markets in this report have fully demutualized their stock The discussion in this section reviews issues and op- exchanges.111 In Malaysia and the Philippines, the tions regarding the regulatory framework for securities exchange has been structured as a public company BOX 5.4 New Ways for Medium-Size Companies to Access Capital: Mexico's New Securities Law In Mexico, the new securities law--to come into effect by mid-2006--introduces a new type of company that will pre- sumably have better access to capital markets. Traditionally there have been two main types of companies in Mexico: the standard company (Sociedad Anonima) and the fully listed company. The corporate governance standards of the two groups differ widely, and this gap has widened as the governance of listed companies has strengthened. The new Law establishes an "intermediate" company called SAPI (the Spanish acronym for an investing promoting corporation). A company of this type is required to have a stronger corporate governance regime, in return for exemp- tions to Mexican company law, which prohibits the transactions commonly used in private capital market deals such as shareholder agreements. In addition, SAPIs will be able to list on the exchange with a three-year grace period for con- forming to the regime required of listed companies. A company's adoption of the SAPI regime is voluntary. The rationale is that the company will thereby be able to sig- nal to the broader capital markets (private equity and debt deals) that it offers better creditor and shareholder rights than does a standard (non-listed) company. But, since the information-disclosure regime required of SAPIs is less stringent than that of publicly listed companies, only institutional investors, or private investors who have signed a waiver, will be allowed to invest in them. Deepening the Securities Markets 123 BOX 5.5 Demutualization: Corporatization of the Stock Exchange Demutualization is the process of commercialization of a stock exchange, and includes separating brokers' rights to deal on the exchange from the ownership and management of the exchange. In demutualizing, a stock exchange is converted into a for-profit limited liability company, whose board and management are no longer simply accountable to brokers or the government but are responsible to a wide range of shareholders. An exit mechanism for shareholders may be pro- vided by the company listing on its own or on another exchange. Access to trading on the exchange is provided by the exchange entering into contractual relationships with individual brokerage firms. The primary business of a demutualized exchange continues to be the operation of a trading system that routes orders from the buying and selling of securities by intermediaries that are authorized to deal on the exchange, and executes trades resulting from the matching of those orders. Stock exchanges that undertake self-regulatory activi- ties generally retain those functions, or at least some of them, after demutualization. The supervisory responsibili- ties of an exchange include surveillance of trading on its market, supervising the conduct of market intermediaries, and monitoring and enforcing compliance with its listing rules by companies whose securities are traded on the exchange. whose shares are quoted on its own exchange, while cease to allocate the resources needed to fulfill its reg- in Hong Kong (China) and Singapore, the exchange ulatory functions, if it comes under commercial pres- has become a subsidiary of a public company whose sure to cut costs in areas that do not generate income. shares are quoted on the exchange. In Indonesia and Others fear that commercialized exchanges may begin Korea, the exchange is an unlisted public company to charge fees for data and trade information, rather whose shares are held by a broad range of banks, than allowing the free disclosure that is fundamental financial intermediaries (including brokers), and for market efficiency and integrity. Concerns are also listed companies (Table 5.12). Unlike in the more raised about the ability of a commercial exchange to mature advanced industrialized countries, where the remain unbiased by self-interest, or to take enforce- move to demutualize came from the exchanges them- ment action against, and impose sanctions on, listed selves, in the East Asia region the governments and companies or market participants that breach their securities regulators have taken the lead in promot- operating rules, given that these institutions provide ing and facilitating the restructuring. major sources of revenue for an exchange. Demutualization does raise some regulatory These concerns have elicited a variety of responses issues. In particular, conflicts of interest may arise internationally. Exchanges that have continued to per- between the commercial business objectives of the ex- form all their supervisory functions following demu- change and its self-regulatory functions. There are tualization, such as those in Singapore and Australia, concerns about whether a demutualized exchange will have successfully maintained that these functions are TABLE 5.12 Status of Demutualization Functions of stockbrokers' Economy Demutualized? Listed? self-regulatory organization retained? China No No -- Indonesia Yes No Yes Rep. of Korea Yes, but not yet regarded No Yes as commercial enterprise Malaysia Yes Yes Yes Philippines Yes Yes Yes Thailand No No -- Hong Kong (China) Yes Yes Yes, in part Singapore Yes Yes Yes Source: World Bank. Note: -- not applicable. 124 East Asian Finance integral to protect their reputation and hence to their become more competitive, to the benefit of investors. continuing commercial viability, and that they them- The risks arising from exchanges operating as com- selves are best equipped to undertake these functions mercial enterprises appear to be comfortably man- efficiently. In the case of NASDAQ, a separate sub- aged. However, it is still too early to assess how much sidiary of NASD (NASD Regulation), has been estab- the demutualization of exchanges will contribute lished to regulate the NASDAQ stock market. In to capital-market development, or will enhance the Canada, a joint venture has been set up between the international competitiveness of these exchanges. Toronto Stock Exchange and the Canadian Dealers' Association to regulate market intermediaries at arms Moving from a merit-based to a length from the demutualized exchange. In some disclosure-based regulatory system jurisdictions, the securities regulator has taken over the regulatory functions formerly undertaken by the A move is also underway to replace merit-based with exchange; for example, in Hong Kong (China), the disclosure-based systems for regulating the primary Securities and Futures Commission (SFC) conducts offering of securities. broker supervision, and in the United Kingdom, Merit-based regulation subjects any issue, offer, where the United Kingdom Listing Agency, a division or listing of securities to a regulator's review of the of the Financial Supervisory Agency, regulates com- merits of the investment. Thus the regulator assumes pany listings. a direct role in protecting investors, interposing itself In many jurisdictions, mechanisms have been between the issuers and investors. The merit-based introduced to reinforce the public-interest role of an approach is generally suitable at the earlier stages exchange following demutualization. Their purpose of capital-market development, where the level of is to address potential conflicts of interest and to investor education is relatively low and the amounts avoid unnecessary risks that could adversely affect raised on the capital markets are relatively small. As the financial viability of the exchange. In Hong Kong the amounts raised on the capital markets increase, (China) and Singapore, for example, the law provides and funding proposals become more innovative and that the public interest must prevail over the business intricate, the costs of approval and compliance for interests of the exchange, and an ownership restric- both issuer and regulator become increasingly burden- tion has been placed on the exchange to ensure that some. High costs can stifle efficient capital invest- all shareholders who acquire a substantial interest in ments and limit the scope of investment opportunities the exchange are vetted. In both cases, a 5 percent for both entrepreneurs and investors. shareholder limit is applicable, although the gov- Disclosure-based regulation rests on the principle ernment or securities regulator can raise the limit as that issuers and the intermediaries that are offering the appropriate to accommodate a strategic investor or securities need to provide investors with sufficient, ac- an alliance with another exchange. curate, and timely disclosure of relevant information It is important that the regulatory response to pertaining to the company's business, finances, demutualization be kept under review and adjusted prospects, and terms of securities, so that investors can from time to time to meet changing conditions. In evaluate the risks and merits of their potential invest- Hong Kong (China), where the exchange is respon- ments. The information is generally provided through sible for approving the public offering of securities, SFC's external oversight of listings on the exchange is a prospectus and the emphasis is therefore on compli- being enhanced through new legislation on exchange- ance with applicable standards. In addition, investors listing rules, which also provides stronger penalties are expected to carry out their own due diligence, per- with which SFC can enforce issuers' compliance with haps with the help of professionals (lawyers, accoun- the rules. tants) and to assume a higher level of responsibility in Demutualization in East Asia has provided the evaluating the risks of a particular offering. means for exchanges to consolidate, restructure, and Under a disclosure-based regulatory regime, modernize. It could facilitate consolidation at the enforcement is delegated to self-regulatory bodies regional level, as it has put in place the framework such as stock exchanges and professional associations. for cross-border ownership of these exchanges. It has The role of the regulators concentrates on overall also permitted brokers to cash out their membership enforcement of laws and regulations to ensure that from an exchange, and has forced brokerage fees to the interests of investors are well protected and that Deepening the Securities Markets 125 market participants follow sound business practices, (2) ensuring that markets are fair, efficient, and trans- adhere to the standards, and comply with laws and parent; and (3) reducing systemic risk.113 These regulations. objectives are supported by 30 core principles, which The benefits of a shift to a disclosure-based system are stated at a general level and permit consider- are seen to be: able flexibility in implementation, reflecting the broad scope of responsibilities that most securities regula- more efficient capital markets--because a merit- tors have. based regulatory system becomes too burdensome Principles 1­5 relate to the regulator and to its for both issuers and supervisors when the sophis- power, resources, independence, and accountability; tication of financial markets increases; principles 6­7 relate to self-regulatory organizations higher standards of disclosure, due diligence, and and to their supervision; principles 8­10 relate to corporate governance, as well as accountability enforcement; principles 11­13 relate to cooperation, by promoters and directors of public companies including international cooperation for regulatory and and their advisers to investors; and enforcement purposes; principles 14­16 to issuers greater market-driven discipline in the pricing and disclosure of information; principles 17­20 relate and valuation of securities. to collective investment schemes and their opera- tion; principles 21­24 to the supervision of market Currently in the region, the regulatory systems in intermediaries; and principles 25­30 relate to the Hong Kong (China), Korea, Malaysia, and Singapore integrity of the secondary market, including the need are disclosure-based, while that in Thailand is a for robust clearance and settlement systems to ensure mixture, moving toward a disclosure-based system. fair, effective, and efficient securities transactions Systems in China, Indonesia, and the Philippines are and to reduce systemic risk, which is addressed in still largely merit-based. principle 30. Malaysia's experience in moving from a merit- The 54 assessments completed globally by IOSCO based to a disclosure-based regulatory system offers as of April 2004 show that implementation has tended lessons for other countries in the region. The key to be relatively weak for those principles (8­10) that building blocks that Malaysia used to implement its govern the enforcement of securities regulations, and disclosure-based regime were prospectus reform; for principles for issuers (14­16). Overall, regulators investor education to enhance investor awareness; lack the authority to investigate; have limited access enhancement of expertise and professionalism among to the time-sensitive data needed for surveillance market professionals; ensuring compliance through purposes; have insufficient resources for inspection, effective surveillance and enforcement; and organi- surveillance, and investigation; and often have a lim- zational restructuring (resulting in the establishment ited enforcement mandate. With respect to issuers, of four specialized departments within the Securities there is a clear need for more efficient methods to Commission).112 The move took about seven years to disseminate information to the public and to improve complete in a phased manner, with several guidelines the quality of the information being released. issued to enable market participants to fully under- The assessments also show a need to improve the stand their responsibilities and the rules of the game. overall legislative and policy framework relating to Two especially notable guidelines (issued in April the treatment of shareholders, a need to enhance the 2003) are those on private-debt securities and those regulatory regime for auditors, and a need to address on asset-backed securities. the lack of harmonization between international and domestic accounting and auditing standards. Other common problems include a need for regula- Broader regulatory and supervisory tions appropriate to deal with collective investment framework for securities markets schemes, and a need to expand the scope of regulators' The principles of the International Organization of responsibilities. To achieve their investor-protection Securities Commissions (IOSCO) set out, in broad objective and ultimately ensure the stability of the sys- terms, the key elements in ensuring an effective sys- tem, securities regulators must cast a broad enforce- tem of securities regulation. Such a system has three ment net to detect and prevent both accounting and core objectives: (1) ensuring investor protection; financial fraud between intermediaries and their 126 East Asian Finance clients and in public statements by issuers. In addition, Singapore also have the most stable securities mar- the scope for cooperation and exchange of informa- kets in the region. Their bond markets are not among tion among securities for law enforcement purposes the region's largest117 but their corporate bond mar- is often quite wide-ranging. kets are quite large and fairly liquid. Few formal assessments have been carried out in Korea and Malaysia are in the next tier in terms the context of the Financial Sector Assessment Pro- of size. Both have large equity markets, although that gram thus far in East Asia.114 However, as discussed of Malaysia is not yet as efficient as those of Korea, earlier, many of the areas that are weak in the global Hong Kong (China), or Singapore. Both have rea- context appear to be weak in East Asia as well--in sonably large and diverse bond markets,118 but lack particular the extent and quality of information dis- of liquidity in these markets is an issue, especially in closure by corporate issuers, as well as accounting and Malaysia. As noted, Bank Negara has recently taken auditing problems. And, as discussed in Chapter 6, some measures to improve liquidity. In Korea, the it is also important for the region to have in place government is planning to launch two new bond appropriate regulations for collective investment indexes to help investors compare the performance schemes. of bonds to that of other asset classes. In the third tier are Thailand, Indonesia, the Philippines, and China (in that order).119 All have Conclusions considerable scope for improving the efficiency of Going forward, the bond market--and the corporate their stock markets. Their corporate bond markets bond market in particular--is the segment requir- are still very small indeed (although that in Thailand ing the most attention from East Asian financial is considerably larger and more diverse than the rest) sector policymakers. Thus far, most of the bonds and their liquidity is very limited. In Thailand, the issued in the region are issued by quasi-government reform agenda for securities markets, especially bond bodies or have explicit or implicit guarantees.115 There markets, needs to consider strengthening the primary- is now a need to focus more on enabling investors to dealer system (for example through two-way market- evaluate and assess credit risks for a broader class of making), improving the valuation of fixed-income potential issuers. Measures are needed to promote securities, and developing the repo markets. the creation of government benchmarks along a full In Indonesia, benchmark issues and the develop- maturity spectrum, to enhance the quality of credit ment of a yield curve, along with efforts to strengthen rating, and to help improve corporate governance, the credit-rating agencies and develop the support- disclosure rules, and accounting standards. ing infrastructure, will help. The government has There is also a need to enact measures that can help recently announced additional measures to improve broaden and diversify the investor base to foster the bond market including: (1) promotion of inter- greater liquidity and efficiency. dealer market transactions to improve price discovery; On infrastructure issues, until now, the pri- (2) development of a yield curve through the more mary emphasis has been on developing the market regular issuance of benchmark issues across the infrastructure in an effort to reduce transaction maturity spectrum; (3) implementation of the Bank costs and enhance the overall efficiency of the secu- Indonesia Scripless Securities Settlement System rities markets. The important next step is to develop to enhance the efficiency and reliability of the exist- the supporting infrastructure--repo markets, sec- ing clearing, settlement, and registry system; and urities lending, margin trading, and derivatives (4) development of a transparent and efficient reg- markets--with the requisite regulatory and super- ulatory framework through issuing operational reg- visory underpinnings. ulations and decrees to support the Government Debt There are essentially three tiers of securities mar- Securities Law. kets in the region. Hong Kong (China) and Singapore In the Philippines, large borrowings by the govern- have the largest116 and most developed equity markets ment have crowded out the corporate bond market. in the region. Along with Korea, they also rank higher Most investors prefer to hold shorter-term instru- than the rest of the region in terms of efficiency-- ments, especially since corporate bonds with a matu- although they rank only in the median range in terms rity of more than one year are subject to a 20 percent of efficiency worldwide. Hong Kong (China) and withholding tax. Thus the development of longer- Deepening the Securities Markets 127 maturity benchmark issues calls for attention, as (5) few high-quality issuers, because of administra- does the development of supporting infrastructure tive and quantitative controls on the volume of such as repo markets. (The Philippines has recently corporate bonds that can be issued; (6) the re- announced measures to consolidate issues of govern- strictive investment policies of institutional in- ment bonds, with a view to building a benchmark.) vestors; and (7) limitations on the participation of In China, whose bond market is the largest, many foreign investors. impediments need to be addressed, including: (1) frag- In China, Indonesia, and the Philippines, further mented regulatory frameworks for bond market improvements in information disclosure and cor- development; (2) the absence of internationally cred- porate governance will be important to gain investor ible credit-rating agencies; (3) the lack of transparent confidence. The size and diversity of the institutional and reliable financial information; (4) competing investor base is also limited in all three countries, as trading platforms (exchange versus over-the-counter); discussed in the following chapter. Strengthening the 6 Investor Base The investor base is a key A broader base of investors is a key component needed to further develop the securities markets in East Asia. In particular, it is im- element in supporting the portant to develop a wide, heterogeneous investor base with dif- development of capital ferent preferences and risk appetites. Contractual savings (pension markets. Assets of institu- and life insurance) can affect the development of securities. First, they provide institutional arrangements for the accumulation of tional investors in the re- long-term capital; they may have a longer time horizon than other gion have grown over the investors and may therefore require lower term premiums on past few years and now fixed-income securities. Second, they may be active traders of se- curities, thereby contributing to the liquidity of capital markets. account for about 45 per- Also important is the development of a mutual fund industry that cent of the region's GDP can cater to retail investors with different needs and risk appetites; this in turn can significantly contribute to trading and liquidity. in aggregate. However, The assets of institutional investors in East Asia have grown there is scope for further over the past few years and at the end of 2004 amounted to growth in institutional US$1.5 trillion, or around 45 percent of GDP in the region as a whole (Table 6.1). Clearly, though, there is considerable variation assets and for institutional in the size of the assets across countries--with the institutional investors to play a greater investor base still very small as a percentage of GDP in China, Indonesia, and the Philippines. role in capital market Against this backdrop, this chapter looks at the role that the development. For retail contractual savings sector can play in further developing the secu- investors, it is important rities markets in the region. It then looks at the issues pertaining to the development of the mutual-fund industry, which accounts for to develop the mutual- about half the investor base and is particularly important for the fund industry. retail investor segment. Pension Funds Pension systems in the region differ widely in their institutional design, coverage, maturity, benefit provision, value of assets under management, and asset allocation--all of which can directly affect the actual and potential impact of pension funds on the develop- ment of capital markets (Table 6.2). The pension system in the Republic of Korea is part of a larger social security system that also covers social assistance and social welfare services. As such it is largely composed of public defined- benefit schemes. The National Pension Scheme (NPS)--whose as- sets are the largest, accounting for about 17 percent of GDP-- 129 130 East Asian Finance TABLE 6.1 Assets of Institutional Investors Pension Life insurance Mutual funds Total US$ % of US$ % of US$ % of US$ % of Economy billions GDP billions GDP billions GDP billions GDP China 28.0 1.6 136.0 7.9 27.0 1.6 191.0 11.1 Indonesia 5.4 2.1 10.5 4.2 11.1 4.5 27.0 10.9 Rep. of Korea 161.0 21.4 133.0 17.7 186.0 24.7 480.0 63.8 Malaysia 70.0 59.2 21.0 17.8 23.0 19.4 114.0 96.4 Philippines 7.9 9.2 2.7 3.1 1.4 1.6 12.0 14.0 Thailand 20.0 12.0 17.0 10.2 19.0 11.4 56.0 33.6 Hong Kong 38.0 22.9 9.0 5.4 465.6 280.3 512.6 308.6 (China) Singapore 68.0 61.2 33.0 29.7 28.0 25.2 129.0 116.0 Total East Asia 398.2 11.8 362.2 10.8 761.0 22.6 1,521.7 45.2 Sources: HSBC 2005; Dalla 2005, BNM, BOT. Note: Figure for mutual funds in Singapore only includes Singapore dollar funds domiciled in Singapore. serves employees of private companies and self- Provident Fund (EPF). As of 1998, EPF accounted employed persons. There are three special occupa- for more than 85 percent of the assets managed by the tional pension schemes: the Government Employees' Malaysian provident fund system. Established in 1951, Pension Scheme (GEPS), the Military Personnel it is one of the oldest pension arrangements in the Pension Scheme (MPPS), and the Private School region (together with Singapore's) and is a mature sys- Teachers' Scheme (PSTPS). Korea also has a private tem. In aggregate, pension funds in Malaysia amount pension system composed of voluntary individual to about 60 percent of GDP. pension plans for the general public and a manda- In Thailand, the pension system is small but com- tory Retirement Allowance Scheme which, although plex, with a large number of schemes covering dif- not a pension plan, functions as a post-retirement ferent portions of the working population but with protection mechanism for people working in work- low overall coverage. Private-sector employees are places with more than five employees. Korea's total covered by the mandatory Old Age Pension Fund pension assets amount to about 21 percent of GDP. (OAPF), which is part of a larger Social Security Fund Malaysia's pension system comprises a series of (SSF) managed by the Social Security Office. Central provident funds, the largest of which is the Employees' government officials are covered by the Government TABLE 6.2 Asset Size and Type of the Most Important Pension Schemes Pension assets Pension assets (US$ billions) (% of GDP) Most important scheme Most important Most important Year Economy Total scheme Total scheme established Type Benefits Indonesia 11.5 Jamsostek 3.8 4.6 1.5 1995 DC Lump sum Rep. of Korea 161.0 NPS 128.6 21.4 17.1 1986 DB Annuities Malaysia 70.0 EPF 63.3 59.4 53.7 1951 DC LS or PW Philippines 10.0 SSS 3.5 10.2 3.6 1948 DB LS or PW Thailand 20.0 SSF 6.7 12.2 4.1 1990 DB Annuities Hong Kong 38.0 MPF 15.5 23.3 9.5 2000 DC Lump sum (China) Singapore 68.0 CPF 68.0 63.7 63.7 1955 DC Lump sum Notes: NPS = National Pension Scheme. EPF = Employees' Provident Fund. SSS = Social Security System. SSF = Social Security Fund. MPF = Mandatory Provident Funds. CPF = Central Provident Fund. DB = defined benefit. DC = defined contribution. LS = lump sum. PW = programmed withdrawal. Strengthening the Investor Base 131 Pension Fund (GPF), which is an unfunded and non- latter has larger assets, the SSS is more important contributory defined-benefit scheme. Local govern- given its extensive coverage of the private-sector ment officials are covered by their own individual workforce. The assets of these two pension institu- defined-benefit schemes, while private teachers are tions total 10 percent of GDP. Other branches of gov- covered by a separate provident fund. There are also ernment, notably the military and police, are covered two voluntary schemes for corporations and indi- by a separate system; the Armed Forces of the Philip- viduals: provident funds and retirement mutual funds pines' Retirement and Separation Benefit System respectively. Total pension assets amount to only (AFP-RSBS). Various individual pension instru- around 12 percent of GDP. ments including pre-need pension plans and Hong Kong (China) recently reformed its pen- employer-sponsored provident funds also exist. sion system with the introduction of the Mandatory Overall, then, pension assets in the region are still Provident Funds (MPF), regulated by the Mandatory relatively small. Only Singapore's Central Provident Provident Fund Schemes Ordinance. Thus the pen- Fund (CPF) and Malaysia's Employees' Provident sion system in Hong Kong (China) comprises both Fund (EPF) have assets that exceed 50 percent of pre-reform institutions and the new MPFs, and in GDP. However, since both these schemes also have total amounts to about 23 percent of GDP. non-pension related mandates, the amount of assets Singapore's pension system relies almost entirely effectively connected to the pension function is smaller on a single, state-managed mandatory savings system than might appear.120 Pension funds in the other based on individual accounts. This system is admin- countries amount to less than 25 percent of GDP. istered by the Central Provident Fund, falling under And although Korea, the Philippines, and Thailand the purview of the Ministry of Manpower. Two other have national defined-benefit schemes (which, in mandatory but non-contributory pension schemes view of their long-term liabilities, may be expected to are in operation: one for government employees and have the strongest demand for fixed-income securi- one for the armed forces. There is also a voluntary ties), these pension schemes are relatively immature, retirement scheme, the Supplementary Retirement and their need for investment instruments is still Scheme, introduced in 2001. Pension assets amount quite small. to 64 percent of GDP. What is the current asset allocation of the pension In the Philippines, the pension system mainly com- funds in the region?121 In general, based on available prises the mandatory, publicly managed Social Secu- information, the asset allocation appears to be fairly rity System (SSS), a scaled-premium, defined-benefit conservative, being mainly confined to government scheme that covers most private-sector employees, securities and bank deposits (Table 6.3). The excep- and the Government Service Insurance System (GSIS), tion is Hong Kong (China), where pension assets are which covers public-sector employees. Though the largely held in equities. TABLE 6.3 Broad Allocation of Pension Fund Assets (Percent of Total) Claims on Claims on public financial Corporate Foreign % of Economy sector sector bonds Equity sector Other GDP Indonesia 13.5 49.4 23.0 5.2 0.0 8.9 0.05 Rep. of Korea 43.5 0.9 11.1 3.2 2.8 38.5 19.8 Malaysia 38.5 8.8 31.0 19.7 n.a. 2.0 53.7 Philippines 15.0 -- -- 33.0 -- 3.8 -- Thailand 39.9 29.0 14.2 11.3 2.8 2.8 12.7 Hong Kong n.a. 20.0 -- 54.0 -- 26.0 9.5 (China) Singapore 96.2 n.a. n.a. n.a. n.a. 3.8 62.0 Notes: Hong Kong (China) figures are for Mandatory Provident Funds only. Figures include domestic and foreign investments. "Other" represents debt securi- ties. Singapore figures do not include the investment schemes. Malaysia figures are for the Employees' Provident Fund only, and those for the Philippines are for the Social Security System only. n.a. = not available. -- = no allocation to that category 132 East Asian Finance This allocation pattern is broadly similar to fund Increasing the size of assets allocations in emerging markets more generally, as under management surveyed by Hess and Impavido (2003), who look at Potentially, pension assets may increase through the allocation of assets in 26 public pension funds. It several channels: (1) if there is scope for extending contrasts with the pattern in the Organisation for pension coverage; (2) through the reversal of any Economic Co-operation and Development (OECD) taxation regime that may be discouraging savings by countries, where public pension schemes invest taxing them twice; or (3) if there is scope to increase 48 percent of their financial assets in equities (domes- contribution rates.123 These are discussed in turn. tic and foreign), and 30 percent of their assets in for- eign securities.122 Pension coverage Thus two main factors currently limit the con- Pension coverage ratios vary considerably across tribution of pension funds to the development of countries (Table 6.4). The Hong Kong (China) pen- securities markets. First, pension assets in most coun- sion system has the highest coverage, at 79 percent of tries are still small. Second, the investment allocation the labor force and 41 percent of the total population. of these assets is largely skewed towards government In the Philippines, the coverage of the Social Security securities and bank deposits. The key questions are System is quite high, at 74 percent of the labor force, therefore: but only one third of the members are active contrib- utors. Coverage in Korea is also high; the National What is the potential for increasing the role Pension Scheme (NPS) is open to all resident citizens of pension funds in developing capital markets aged between 18 and 60 years of age. In 1997, NPS (while maintaining their primary objective) covered only about 37 percent of the labor force, but through an increase in the size of assets? mandatory coverage was extended in 1999 to the Broadening the investment allocations of pension urban self-employed, employees in companies with funds could also provide a greater impetus to fewer than five workers, non-income earners, and for- securities market development. To what extent eigners, bringing the coverage up to about 73 percent could a loosening of investment regulations help? of the labor force. In Singapore, the Central Provident What other reforms or changes could be under- Fund covers 77 percent of the eligible population but taken that would both advance the objectives of only 56 percent of the labor force,124 largely because pension funds and encourage a greater use of foreign workers (who account for around 25 percent capital markets? of the labor force) are excluded from the covered pop- What other key elements do countries need to ulation. In Malaysia, the Employees' Provident Fund strengthen in tandem if investment restrictions covers about 45 percent of the labor force. At the low- are loosened and investment allocations broad- est end of the spectrum in terms of coverage is Thai- ened, to help ensure that the safety and soundness land, whose Social Security Fund (SSF) is estimated to of the pension systems are maintained? cover about 21 percent of the labor force. A few cate- TABLE 6.4 Coverage Ratios of Pension Schemes Active members Members/covered Members/labor Members/total Economy (thousands) population (%) force (%) population (%) Indonesia 14,100 42.7 14.0 6.6 Rep. of Korea 17,070 n.a 73.0 37.1 Malaysia 5,070 n.a 45.5 19.8 Philippines 8,925 n.a 74.0 31.0 Thailand 10,351 72.0 29.0 16.8 Hong Kong (China) 2,832 95.5 79.4 41.2 Singapore 1,324 77.0 56.6 31.2 Notes: Korea: National Pension Scheme only. Malaysia: Employees' Provident Fund only. Philippines: Social Security System and Government Service In- surance System only. Strengthening the Investor Base 133 gories of workers within the labor force are exempt is usually dictated by fiscal considerations. TEE and from contributing to the SSF, but the main reason for EET regimes are in general not equivalent: other things the low coverage is that a large share of the labor force being equal, taxation will be lower in the latter than works in the informal sector. Including the Govern- in the former, owing to tax deferral. ment Pension Fund, coverage amounts to about In practice, the tax treatment of pension savings 29 percent of the labor force. in East Asia is very generous. In Hong Kong (China), Pension coverage in East Asia is relatively good the exempt-exempt-exempt (EEE) rule is generally compared to the average in Eastern Europe and, followed: contributions to the Occupational Retire- in particular, Latin America (whose averages are ment Schemes Ordinance ORSO and MPF contri- 63 percent and 35 percent respectively). But com- butions are tax-exempt.126 Thailand follows the same pared to the more advanced Latin American countries rule for its public schemes. In Thailand's voluntary and the OECD, where average coverage is 90 percent provident funds, tax exemption ceilings apply to of the labor force, there is scope for increasing effective contributions, and benefits arising from the invest- coverage in several East Asian countries and partic- ment of the funds are all exempt from tax. The EEE ularly in Indonesia, the Philippines, and Thailand. rule is also applied in the Philippines' Social Security At the same time, it should be recognized that the Fund and Government Service Insurance System, share of the informal labor force is in these countries exempting from taxes, fees, or charges all their is still relatively large, making it difficult to increase assets, collected contributions (and all accruals coverage until more of these workers are brought thereto), income and investment earnings, and all into the formal labor market. benefits. In Korea, pension savings follow the EET Taxation rule for the National Pension Scheme and the EEE rule for the Government Employees' Pension It is important to give pension savings an equitable Scheme. In Singapore, the tax treatment of savings and consistent tax treatment in order to promote the through the Central Provident Fund follows the accumulation of long-term savings for retirement. EET rule. Only annuities or lump sums under the International experience--and economic logic-- Minimum Sum Scheme enjoy tax exemption. In suggests that an appropriate tax treatment is achieved Malaysia, the tax treatment of pension savings in the when contractual savings (through social security, Employees' Provident Fund follows the EEE rule with occupational pension funds, and life-insurance com- varying deductibility ceilings on contributions. panies) are taxed only once. There are two alternative In sum, taxation does not constrain the growth ways to achieve this. The first is to collect income tax of pension assets in the region.127 from the contributions to the contractual savings plan and to exempt from income tax the investment Contribution rates income from contractual savings institutions and The contribution rates to pension schemes in East from the distribution of plan benefits. This is known Asia are generally quite low, with the exception, at as the taxed-exempt-exempt (TEE) alternative. The second is to exempt from income tax both the contri- least in nominal terms, in Malaysia and Singapore butions toward the purchase of a contractual savings (Table 6.5). Nominal contribution rates in Hong plan and the investment income of the contractual Kong (China) are only 10 percent of the total wage bill savings institution, while making plan benefits liable or 1.8 percent of GDP. In Thailand, nominal contri- to income tax--this is known as the exempt-exempt- bution rates to the Social Security Fund are only 6 per- taxed regime (EET). cent of the covered wage bill (that is, the total wage bill These two alternatives are expenditure regimes in of the population covered by the plan). In Korea in which the post-tax rate of return is expected to equal, 2004, nominal contributions to the national Pension in present-value terms, the pre-tax rate of return. Scheme amounted to 9 percent of the covered wage Therefore, consumption is taxed at the same rate now bill and hence to only 2.2 percent of GDP; the contri- as in the future. Such a tax regime is usually preferred, bution ceiling is around twice the average covered as it avoids taxing savings twice and encourages the wage, indicating an effective contribution rate of less accumulation of contractual savings for retirement than 9 percent of the total wage. In Singapore, em- purposes.125 The choice between the two alternatives ployees less than 50 years old contribute 33 percent of 134 East Asian Finance TABLE 6.5 Nominal Contribution Rates of Main Pension Schemes Employee Employer Credited to Contributions rate rate retirement from main scheme Economy Scheme (%) (%) account (%) (% of GDP) Indonesia Jamsostek 2.0 3.7 4.4 0.2 Rep. of Korea NPS 4.5 4.5 9.0 2.2 Malaysia EPF 11.0 12.0 13.8 4.9 Philippines SSS 3.3 6.1 9.4 0.7 Thailand SSF 3.0 3.0 6.0 0.6 Hong Kong (China) MPF 5.0 5.0 10.0 1.8 Singapore CPF 20.0 13.0 7.0 8.5 Notes: NPS = National Pension Scheme. EPS = Employees' Provident Fund. SSS = Social Security System. SSF = Social Security Fund. MPF = Mandatory Provident Funds. CPF = Central Provident Fund. the relevant wage bill, and total contributions to the and often have quantitative floors for government Central Provident Fund represent only 8.5 percent of securities.129 GDP. The special account that is used to finance re- In Thailand, the investment rules of the Social tirement benefits receives only around 7 percent of Security Fund and Government Pension Fund are GDP. In Malaysia, nominal contribution rates are governed by a ministerial regulation and by the in- 23 percent of the covered wage. While contributions vestment policies established by the Social Security are levied on total remuneration, only 60 percent of Office and Government Pension Fund (GPF) the proceeds (equivalent to 13.8 percent of the wage boards. For the GPF, the rules include a 60 percent bill) are used to finance retirement benefits. As a re- investment floor in "highly secure securities," which sult, in 2004, total contributions to the Employees' appear to exclude equity and non-rated corporate Provident Fund amounted to 4.9 percent of GDP. In debt. Various investment ceilings apply to other the Philippines, the contribution rate to the Social Se- securities; for instance, no more than 10 percent of curity System is only 9.4 percent, which works out to assets can be invested in equity or in foreign assets. 0.7 percent of GDP. In the Government Service In- On the basis of these rules, GPF designs its strate- surance System, the contribution rate is much higher, gic allocation of up to 70 percent of assets in cash, deposits, and government fixed-income securities; at 21 percent (9 percent for employees and 12 percent up to 15 percent in private-sector instruments; up to for employers) and thus, even though the active mem- 5 percent of assets in foreign equity; up to 5 percent bership of this scheme is only one fifth of that of the in foreign-debt instruments; and up to 5 percent in Social Security System, its contribution to GDP is real estate. Its investment policy does not refer to almost as large. risk management or benchmarks. For the voluntary Several countries may have scope to increase their provident funds and retirement mutual funds, the nominal and/or effective contribution rates while investment regulations restrict fund managers to keeping their pension systems affordable and able to investing in securities approved by the Securities and provide adequate income-replacement rates.128 It is Exchange Commission (quality assets concept), with these two considerations, rather than the need to help investment limits set up by these funds' own invest- develop capital markets, that should drive decision ment policies (diversification concept). The invest- making on pension contributions, even though it is ment limits are designed to ensure that investments clear that increasing the contribution rates would in grade securities issued by any company do not ex- enlarge the volume of savings that pension systems ceed 15 percent of net asset value (or 20 percent of intermediate. net asset value for those financial institutions under Central Bank supervision). A company's investment Diversifying investment allocations in non-investment grade securities may not exceed 5 percent of net asset value and should be lower than Except in Hong Kong (China), regulations on the 15 percent in aggregate. investment of pension funds are quite conservative Strengthening the Investor Base 135 In Malaysia, the investment policy of the Employ- The conservative investment regulations generally ees' Provident Fund (EPF) is regulated by the EPF observed in the region are typical of those governing Act of 1991, the Trustee Act of 1949, and by the public pension schemes in emerging economies. Hess EPF policy guidelines set by the fund's investment and Impavido (2003) survey the investment regula- committee (Asher 1999). EPF is required to keep tions of public pension funds in 26 emerging markets 70 percent of its assets in Malaysian government secu- and find that the use of restrictions and mandates is rities, but the government has waived this require- widespread, with the most common restriction being ment due to the shortage of these securities. EPF is on foreign investments. They find that 57 percent of allowed to invest up to 25 percent of its assets in the funds face prohibitions on investments abroad, equities. Foreign investments are also allowed, but 14 percent face prohibitions on equities, and 19 per- at present only a very small share of assets is invested cent on loans. Some 60 percent of the funds operate abroad, mainly in Asian bonds and equities. under at least one type of mandate. These mandates In the Philippines, the Social Security System include requirements to invest in government bonds, (SSS) charter gives the SSS Commission the power whether national, state, provincial, or municipal to manage and invest the reserve funds in line with (48 percent of the funds surveyed); in social projects the basic principles of safety, good yield, and liquid- such as housing (24 percent); and in general economic ity. The key ceilings for investment are 7.5 percent development (32 percent). for foreign-denominated investments, 40 percent The OECD countries have much looser rules for for private securities, and 30 percent for govern- pension funds. Among 29 OECD countries (exclud- ment financial institutions and corporations. The ing Korea), nine have no limits on any investment SSS's actuary is required to submit a valuation re- categories (equity, real estate, bonds, investment port to the SSS benefit program at least every four funds, loans, or bank deposits). Thirteen have no years. In the Government Service Insurance System limits on equity investment, eight have a limit of at (GSIS), the Board has the power to invest the re- least 50 percent, and five have limits between 50 and serves according to parameters identified in the 25 percent of total assets in equities. Regulations GSIS charter. GSIS must make available at least regarding bonds are also flexible, and 22 countries 40 percent of its funds for loans to its members (the have no limits on bond investments. Nineteen coun- actual proportion is currently around 45 percent)-- tries have no limits on bank deposits. In five countries a requirement that limits the ability of this pension that do limit bank deposits, the limits are usually scheme to contribute funds to the development of below 20 percent, in recognition of the low profitabil- capital markets. Periodic actuarial valuation is re- ity of such investments. quired but no time frame is suggested; GSIS is also As discussed above, in several cases the actual required to provide an annual report on all its investment allocations of pension assets in East Asia investments to Congress. seem to be even more conservative than the restric- In Korea, no detailed regulation applies to the tions permit. What policy changes could encourage National Pension Scheme, but the investment universe a greater use of securities markets while advancing of the National Pension Corporation (NPC) is defined the goals of the pension funds themselves? by the Fund Management Committee according to the National Pension Act and ministerial ordinances. Liability-based management NPC's investment strategy is regularly reviewed by For public defined-benefit schemes, such as those in external professional advisers. Investment regulations Korea, the Philippines, and Thailand, an important allow the corporation itself to manage domestic bonds beneficial reform would be to account for pension and equities as well as foreign bonds. The same reg- liabilities when pension rights are accrued.130 Under ulations require NPC to outsource the management these countries' current accounting rules, like those of foreign equities, real estate, and private equities. of most other countries in the world, public pension External asset managers are selected through public liabilities are not recorded, while public contributions competitions following the transparency standards are recorded as government revenues (under social contained in the procurement guidelines applicable contributions) and pension payments are recorded to public contracts. Consulting firms are used to as transfers to retirees. If pension liabilities were to select foreign asset managers. be accounted for when pension rights accrue--with 136 East Asian Finance the contributions that give rise to such rights treated of pension assets into such long-term securities would as financial transactions and pension payments treated be problematic, because liquidity constraints could as reductions in pension liabilities--this would help lead to substantial short-term price volatility. to highlight the fact that, from the perspective of the sponsor of a defined-benefit plan, pension-fund Increased annuitization management is an asset-liability-management prob- For defined-contribution schemes such as those in lem, and has long-term risks. Such accounting reforms Hong Kong (China), Malaysia, and Singapore, an are now being undertaken in Europe.131 argument could be made for increasing the annu- For defined-benefit schemes, the adoption of an itization component. This would improve both the asset-liability framework would likely encourage inter- and intra-generational risk-sharing proper- greater investments in securities. Managers of such ties of the systems. From the perspective of capital- funds have traditionally focused on investment man- market development, increased annuitization would agement, managing their assets against a return expand the potential of the pension system, by in- benchmark for an asset class. This approach may be creasing the set of professional institutional investors appropriate for defined-contribution schemes with and the demand for long-duration fixed-income no guarantees.132 But it is not appropriate for defined- securities. benefit schemes, given their predetermined liabilities What measures need to be taken in tandem if pen- or obligations. Rather the focus should be on liability sion funds are to shift some of their assets away from benchmarking--whereby a liability index is con- safer but lower-yielding bank and government instru- structed and assets and liabilities are managed with ments toward a more diversified portfolio? regard to the correlation between the two. Liability management and investment manage- Governance framework ment can produce very different asset allocations. For The first set of measures concerns the governance instance, in a fund that is managed with regard to framework of pension funds, which will strongly return benchmarks, one would expect to observe a affect the capacity of the funds to undertake such a large share of equities if mean reversion in equities diversification. exists. In a fund managed against a liability bench- The governance framework in almost all the pen- mark, one would observe a large share of fixed-income sion institutions in the countries covered is based on instruments of long duration, since the liabilities of tripartite, representative boards. Most of these insti- a defined-benefit pension fund behave very much like tutions require their board members to have pension a laddered bond portfolio.133 Pension funds around and fund management expertise, but their "fit-and- the world are increasingly focusing on asset-liability proper tests" are relatively weak. Directors on some management, and in particular, on the relative dura- boards are not remunerated, so it is difficult for in- tion of assets and liabilities. stitutions to hire and retain qualified directors. A A revision of accounting standards would require large share of the directors in most institutions con- that pension liabilities be measured and evaluated in sists of ex-officio government representatives. a way that is consistent with the measurement and The economic literature finds that inconsistent evaluation of assets, and this in turn would encour- performance of pension funds is associated with poor age the adoption of funding rules and strategies for governance. In more developed countries, a direct managing assets through liability benchmarking. link between governance and investment performance Thus the adoption of these accounting rules cannot be established, although governance indirectly in Korea, the Philippines, and Thailand, given their affects performance by determining key investment public defined-benefit pension schemes, could have strategies. Representative governing bodies tend to an important impact on capital market development, produce more conservative investment policies than especially on the development of long-duration fixed- do governing bodies composed of professional and income securities. However, as discussed below, for qualified directors. the changed rules to have their full impact would In developing countries, poor governance often also require an increased supply of long-term bonds. reflects an inability to insulate fund management from At present, with the relatively short supply of long- political risk. In these countries, this appears to be term bonds, even a modest increase in the allocation an important determinant of poor performance. Strengthening the Investor Base 137 Two specific governance problems are likely to of local financial markets. Most funds use value-at- have a detrimental impact on fund performance in risk type risk metrics to measure the sensitivity of in- developing countries. The first of these relates to the vestments to price movements. The usefulness of control structure of public pension plans, which is these risk metrics in practice often depends on the generally designed to give equal representation to a liquidity of the underlying instruments and there- large number of stakeholders on the board of directors. fore on the quality of the information conveyed by Multiple and unclear plan mandates induce a strong prices. Moreover, only credit risk is managed actively. bias in a fund's control structure. In practice the Interest rate risk is not managed--even in the defined- presence of social mandates, together with appoint- benefit schemes--although the largest portion of ment procedures that can be less than transparent, the assets in the portfolios of the surveyed schemes weak "fit-and-proper" tests for directors, and the pres- is sensitive to interest-rate risk. Neither is foreign- ence of ex-officio directors, often means that govern- exchange risk, mainly because thus far only an in- ments have a stronger influence on boards' decisions significant proportion of assets are invested abroad. than do other stakeholders, including employers and Hong Kong (China)'s pension sector is an excep- employees. This means that the control structure of tion in terms of governance and risk management. public pension funds is in practice not aligned with The governance framework clearly centers on the role the residual-claimant structure of the funds. of the qualified trustee with strong fiduciary duties. The second governance problem relates to the The regulatory framework contains well-defined collective action of plan stakeholders. Traditional and strong "fit-and-proper" tests for such trustees. delegated monitoring mechanisms such as takeovers While this feature, per se, does not ensure profes- clearly do not apply to public pension funds. This sionalism, it clearly facilitates accountability and means that public pension boards lack the comple- provides an unambiguous legal basis for recourse mentary support of other governance mechanisms against any eventual mismanagement. that are commonly used in corporations. In public In Korea, the National Pension Fund has a tripar- pension funds it is likely that an increased use of tite governance structure, so there is a potential for independent directors and the introduction of explicit politicization of the fund's management. But the behavioral controls can strengthen the monitoring investment-regulation and risk-management stan- function of boards. Both of these expedients should dards established by the risk-management committee reduce the conflicts of interest between directors of the National Pension Corporation have promoted and management and increase the overall trans- investments in secure and liquid, though not neces- parency and accountability of fund management to sarily profitable, assets. The Corporation manages plan members. credit risk by limiting its equity exposure to stocks The complex stakeholder structure of public pen- listed on the Korean exchange KOSDAQ, and by sion funds suggests that no single governance frame- limiting its corporate-debt exposure to instruments work would meet the needs of all funds. But, as the issued by companies whose credit rating is no lower residual claimants of public pension funds, active than "A-" according to at least two domestic credit- members--and taxpayers more generally--should rating companies. Individual issuer limits also apply. be granted more control over boards' decisions than NPC is restricted from holding more than 10 percent they have typically had in the region. This can only be of the number of issues for each equity category of any achieved if the law or plan documents specify clear given issuer, and from investing more than 10 percent commercial mandates, and if the use of independent, of its assets in any given issue. Similar limits guide qualified, and professional directors is maximized. the management of credit risk arising from foreign issuers. In this case, NPC is also allowed to trade in Risk management derivatives to manage the foreign exchange risk. No The second area for supportive policy changes is a other forms of risk are explicitly managed. strengthening of the framework for managing risks. Malaysia's Employees' Provident Fund is also gov- In all the region's pension schemes, this framework erned by a tripartite board but differs from other funds focuses almost exclusively on asset management, with in the region in that a separate body is charged with varying degrees of sophistication depending on the setting the investment strategy and developing the flexibility of the investment rules and the development risk-management framework. EPF is now developing 138 East Asian Finance and implementing a formal risk-management frame- such as credit-default swaps,134 which are often held work, which is expected to revolve around a value- as a means to raise the returns on an asset portfolio, at-risk system with an optimizing routine to select are more complex and their risks are more difficult a more efficient asset allocation. The framework to assess. Hence their use should only be considered will provide recommendations for a risk-governance once the requisite risk-management skills have been structure. EPF is also selecting a system to help in the developed. analysis of market risk. In the Philippines, the Social Security Commission Insurance Sector of the Social Security System (SSS) and the Board of The asset size of the life insurance industry is the Government Services Insurance Scheme (GSIS) still relatively small in most countries of the region are constituted according to their respective char- (Table 6.1). Looking ahead, the potential impor- ters. Members of the Commission are selected by the tance of the insurance industry for capital market de- President of the Philippines, and the broad criteria velopment will depend more on the size of assets used for this process are reflected in the limited tech- than on investment regulations, because in general nical capacity of the Commission to understand the latter are not binding. Of course, the size of these complex technical issues and take appropriate policy assets will depend on the scope for further develop- decisions. The Board of the Government Services ing the industry's coverage and products. Insurance Scheme is also appointed by the President, but the GSIS Charter requires that four of the eight appointee members be from the banking, finance, Increasing the size of assets investment, or insurance sectors and that one be a The most commonly used measures to assess the level recognized member of the legal profession. Neither of development of the sector are insurance penetration the Social Security Commission nor the Board of (measured as the insurance premium as a percentage GSIS uses a formal framework for risk management. of GDP) and density (measured as the premium per However, the 2006 corporate plan of SSS provides capita). There is still substantial scope for further for the establishment of risk-management and com- development, particularly in China, Indonesia, the pliance units. Philippines, and Thailand (Table 6.6). Finally, in Thailand, the board of the Social Secu- Distribution channels are an important factor in rity Fund comprises representative and ex-officio increasing the coverage of insurance. In most insur- members. Minimal "fit-and-proper" tests are defined ance markets in the region, distribution has been built in the Act that governs the appointment of advisers on the agency-sales-force model, often extending to appointed by the Minister of Labor and Social Welfare large numbers of sales forces (with varying degrees (who can appoint up to five such advisers as experts of productivity, reflecting the extent to which agents without voting powers). However, no such tests are work full- or part-time). As such, in many countries, specified for the members of the board. Fund man- a large reach is extended over a small area. agers focus on asset-risk management and more In China, given that country's size, it is natural that specifically on credit risk. Important risks, such as there are more regional differences in access. The inflation or interest rate risks, are not yet managed. China Insurance Regulatory Commission has been To conclude, therefore, pension funds have the encouraging companies to ensure that their services potential to play a greater role in the development of are provided in all areas. For local Chinese compa- securities markets in the region. As they begin to in- nies there is a particular incentive to do so under the vest in a wider range of securities, it will be impor- liberalization agreements of the market. The more tant to ensure that they have appropriate governance advanced markets in the region have introduced banc- structures and stronger technical expertise at their assurance (that is, selling of insurance through a bank's disposal than they do now. established distribution channels), and although it This consideration is particularly important with is early in the experience, and both the authorities regard to the use of derivatives. For instance, as pen- as well as market participants are taking a cautious sion funds begin to hold greater amounts of foreign approach, the signs are positive. Micro-insurance securities, they are likely to need to use derivatives operations are also emerging, with examples from for exchange-rate hedging. Other types of derivatives, Indonesia attracting international attention as case Strengthening the Investor Base 139 TABLE 6.6 Indicators of Development of the Insurance Sector 1997 2000 2004 Economy Penetration Density Penetration Density Penetration Density China life 0.8 6.1 1.1 9.5 2.2 27.3 non-life 0.6 4.7 0.7 5.7 1.1 12.9 total 1.4 10.8 1.8 15.2 3.3 40.2 Indonesia life 0.6 6.2 0.5 4.0 0.6 7.5 non-life 0.7 6.9 0.6 4.6 0.7 8.1 total 1.3 13.1 1.2 8.6 1.3 15.6 Rep. of Korea life 11.6 929.3 9.9 935.6 6.8 1,006.8 non-life 3.8 303.0 3.2 298.5 2.8 412.5 total 15.4 1,232.3 13.1 1,234.1 9.6 1,419.3 Malaysia life 2.2 99.0 2.1 86.4 3.5 167.3 non-life 2.2 99.8 1.6 64.6 1.9 89.3 total 4.4 198.8 3.7 151.0 5.4 256.6 Philippines life 0.7 8.0 0.8 7.5 0.9 9.4 non-life 0.8 9.1 0.6 6.0 0.6 6.1 total 1.5 17.1 1.4 13.5 1.5 15.5 Thailand life 1.2 26.2 1.5 29.8 1.9 50.8 non-life 1.2 26.3 1.0 19.4 1.6 41.4 total 2.4 52.5 2.5 49.3 3.5 92.2 Hong Kong (China) life 2.4 646.3 3.7 892.9 7.9 1,884.3 non-life 1.1 299.2 1.1 269.1 1.4 332.9 total 3.5 945.5 4.8 1,162.0 9.3 2,217.2 Singapore life 3.8 989.0 3.2 732.1 6.0 1,483.9 non-life 1.3 338.3 1.0 234.2 1.5 365.5 total 5.1 1,327.3 4.2 966.3 7.5 1,849.4 Source: Swiss Re, various issues. studies. Diversifying distribution channels is likely uct innovation, so the further development of prod- to improve access to insurance products and to act ucts in each market may be expected to take its course as a vehicle for the sector's growth, enhancing its and enlarge the insurance companies' role as insti- role as an institutional investor. tutional investors. Growth in the range of insurance products of- fered is likely to further the sector's development and Increasing allocations to securities markets growth in assets. A relatively wide range of products, both savings and protection, are already available in A potentially important impetus to capital market all the markets. Savings products in both traditional development might come from consolidation of the forms and the more recently unbundled forms are insurance industry. In several countries in the region, present, along with various forms of pure mortality the industry consists of many small players, in part cover. Insurance for personal accident and health is because legal minimum capital levels for entry into becoming increasingly popular. Non-life insurance the industry are low by international standards products are available, covering the full range of risks, (Appendix Table 6.1). The small size of these com- to support commercial and domestic customers. panies prevents them from playing an important role Across the region, insurers show a capacity for prod- in capital markets. 140 East Asian Finance TABLE 6.7 Indicators of Concentration in the Insurance Sector Herfindhal index Number of companies Economy Year Life Non-life Life Non-life Composite Total China 2004 1,803 3,684 n.a n.a n.a n.a Indonesia 2004 811 478 n.a n.a n.a n.a Rep. of Korea 2004 1,846 1,622 22 17 -- 39 Malaysia 2003 1,683 460 7 26 9 42 Philippines 2004 1,439 424 34 97 4 135 Thailand 2004 2,527 439 24 71 -- 95 Hong Kong (China) 2005 926 229 46 110 19 175 Singapore 2004 1,989 588 6 42 7 55 Note: The Herfindhal index is defined as the sum of squares of the market shares of each individual firm. It ranges from 0 (competitive or equally distributed) to 1 (monopolistic or dominated by one firm). Alternatively, it can range from 0 to 10,000, if percents are used as whole numbers (e.g. 75 instead of 0.75). World Bank comparisons across markets suggest that a Herfindhal index value of around 1,200 to 1,500 would be the natural range for non-life insurance markets, and because of greater economies to scale and lower concerns of risk aggregation, around twice that level for life insurance. -- = not available. The Korean market is one of the few where the can be expected to enhance risk-management skills number of companies is not very large and the over time and to allow countries to move to less Herfindhal index is relatively high, suggesting that restrictive investment regimes. Focusing on capital fragmentation is not an issue either in the life or regulations will also likely lead to consolidation of non-life sectors (Table 6.7). By contrast, in Malaysia, the industry in those countries that currently have a the Philippines, and Thailand, a rationalization of large number of small entities.135 the non-life sector might be beneficial, given the Korea, the Philippines, and Thailand have indi- number of companies and the Herfindhal index value, cated that they will move toward risk-based regimes. while in Indonesia rationalization might be expected Malaysia has indicated that it will introduce a system in both the life and non-life sectors. In these coun- of dynamic solvency testing. The move towards risk- tries, consolidation would produce companies of a based capital requirements reflects a keen interest larger average size, better able to invest significantly throughout the region in strengthening insurance- in the securities markets. solvency regimes in line with emerging international In some countries, loosening investment restric- standards, and a concern that the pre-reform capital tions for the insurance industry could help to stimulate levels may not be adequate in many jurisdictions. A the contribution of the industry to capital-market more risk-based regime would of course raise demand development. Investment regulation in the region for technical skills in both the supervisory authorities ranges from an absence of specific rules in Hong Kong and companies in many countries, which would need (China) to a very restrictive regime in China, which to be met as the industry develops. In sum, a smaller sets out limits for sectors and asset classes. Between number of larger companies, coupled with a more these two approaches is the approach of permitting risk-based capital regime and increased technical skills, investments in a broader range of assets, but requiring would likely enhance the use of risk-management additional capital for particular asset exposure, either techniques. In turn, this would facilitate the move to explicitly or through admissibility rules. Where there a less prescriptive investment regime. are specific quantitative rules, they tend not to be fully prescriptive for all types of asset risks, but to set selective limits either at the global portfolio level or for Mutual Funds specific issuers (and rarely both for every type of asset). The scope of investment regulations for life insurers Given the important role that the mutual fund indus- is summarized in Table 6.8. try can play in deepening securities markets, devel- Several jurisdictions are moving to introduce oping the industry has become an important policy more risk-based capital requirements. This, in turn, objective in the region.136 Strengthening the Investor Base 141 TABLE 6.8 Scope of Investment Regulations in the Life Insurance Sector Economy Scope of investment regulations for life insurers China Investments are subject to specific limits. These are being gradually relaxed from a situation where insurers could only invest in bank accounts and government bonds to one that now permits some foreign investment, corporate bonds, infrastructure bonds (through trusts and permitted vehicles), mutual funds, and domestic equities. Indonesia Limits apply to specific issuers for deposits, publicly quoted shares, bonds and notes, and investment funds. Overall limits apply to foreign equities and bonds, direct investment, real estate, and mortgages. Rep. of Recent amendments have relaxed a system that had quantitative limits addressing both spread and portfolio compo- Korea sition. Remaining limits concentrate on global maximums, with the exception of a limitation on stock concentration by issuer. Malaysia Insurers have a minimum 25 percent obligation to invest in government securities. While other investments are not subject to specific restrictions, the interaction with the solvency regime is relevant. The authorities, for example, re- cently altered the limit that credit facilities, including loans and private debt instruments, can take into account for the purpose of meeting the minimum solvency requirements. Philippines Specific limits on admissibility apply. Issuer-based limits apply to bonds, debentures, and equity issues, and a global limit applies to real estate. There is an obligation to invest 25 percent of the minimum paid-up capital in government bonds. Thailand Detailed limits apply, setting entity level, global portfolio, and, in some cases, combined limits. Hong Kong The authorities look to the company to form a prudent investment policy taking into account the advice of the actu- (China) ary. There are no specific rules or prohibitions relating to particular investment classes. Singapore Insurance assets supporting domestic business are subject to regulations and quantitative global limits as well as limits relating to individual concentrations. Mutual funds have grown quickly in most coun- products have been introduced in recent years. Fig- tries in the region, albeit starting from a relatively ure 6.1 shows the broad asset-class exposure across small base. Except in Thailand, their growth was the region. faster than 20 percent during 2003­04 in all coun- Overall, despite its recent growth, the mutual-fund tries, with China and Indonesia seeing the highest industry has scope for much further development in growth (89 percent and 49 percent respectively).137 most countries in the region, both in size and product By the end of 2004, East Asia accounted for about diversity. But, as discussed below, the dramatic growth 10 percent of the US$16,152 billion global net asset in assets under management has already been ac- value of mutual funds (according to the Invest- companied by problems in some countries, notably ment Company Institute). Assets under manage- Indonesia. Thus it is also important that future growth ment were the largest in Hong Kong (China) (where take place within a well-regulated environment that they amounted to US$465 billion or 285 percent of attracts investors. GDP), and Singapore (US$349 billion or 326 percent of GDP). Both Hong Kong (China) and Singapore Developing the mutual funds industry have set out to be regional centers138 and a large pro- on a sound basis portion of the funds in both countries comes from abroad, by contrast with other countries in the region, The region's experience points to four key elements where the bulk of the money invested is derived locally. that need to be put in place to develop the mutual After Hong Kong (China) and Singapore, assets under fund industry on a sound basis. management are largest in relation to the domestic economy in Korea and Malaysia (20 and 25 percent Ensuring an appropriate and adaptable of GDP respectively), followed by Indonesia, China, regulatory framework and the Philippines. When drafting fund laws and enabling different A wide range of mutual fund products with dif- types of funds to flourish, it is important to consider ferent investment objectives and strategies is available what purposes the funds are to fulfill and to choose to retail investors in Hong Kong (China), Korea, and the structures that are best suited to local conditions. Singapore. The variety of fund products in China, For example, is the primary purpose of the law to Indonesia, Malaysia, and Thailand is still relatively enable investments in liquid securities, or to enable limited, although many new collective investment investments in illiquid assets such as real estate? Is it 142 East Asian Finance FIGURE 6.1 Asset Class Exposure of Investment Funds Asset class exposure in the region equity bonds money market balanced other Hong Kong, China Thailand Rep. of Korea Philippines Malaysia Indonesia China 0 20 40 60 80 100 percent Source: Cadogan Financial 2006. to enable institutional investment in private equity or case in China and Thailand, many emerging markets venture capital? Or, as is likely to be the case in most start with closed-end funds, which are a suitable choice countries, is it a combination of these objectives, in markets that are narrow and illiquid. However, some more applicable now and others more applic- when these funds are launched, they start at a pre- able in the future? And clearly the laws need to be mium, as investors treat them as another initial pub- reasonably up to date if they are not to retard the lic offering (IPO); they then fall dramatically in net development of the asset management industry. asset value (by as much as 50 percent in China) as A key point to note in this regard is that, while fi- the IPO fever wears off. This leads to pressures to nancial markets innovate constantly, laws once create open-end funds in which investors buy and passed are difficult and time consuming to change. sell fund units or shares at their net asset value. Though laws are needed in order to provide a clear However, it is difficult to create open-end funds that legal basis for fund operation and regulation, it is allow investors to buy and sell every day if the assets preferable that they deal only with issues of princi- in which those funds invest cannot also be easily ple and leave the details to subsidiary legislation. To bought and sold in reasonable amounts. accommodate changes such as new forms of funds Problems therefore arise with a rapid expansion or to allow for new investment powers such as de- of the open-end fund sector if there is an inade- rivatives, regulations can be adapted more easily quate supply of suitable assets in which to invest. than laws, but they remain governed by the key This tends to lead investors into lower-quality, principles set out in the law. Hong Kong (China) more risky assets as the best assets get bought up, and Singapore have followed this approach. In other leading to unrealistically low yields and forcing countries, including the Philippines (Box 6.1), out- managers to relax their criteria for asset selection dated legislation has sometimes hindered the devel- in order to continue providing the kind of returns opment of the industry. that investors demand. In turn, such assets tend to The liquidity of assets has a bearing on whether be harder to value and difficult to sell in times of to allow closed-end or open-end funds. As was the need. Strengthening the Investor Base 143 BOX 6.1 In the Philippines, Outdated Legislation Is Delaying the Growth of the Investment Fund Sector The Philippines has been slow to revise its legislation on investment funds, despite the fact that the existing law is acknowledged to be out of date (for instance the Medium-term Philippine Development Plan 2004­10 recognizes the need to implement changes in the law). Currently the asset management industry rests on a law dating from 1960, RA 2629, otherwise known as the Investment Company Act (ICA) and the Implementing Rules and Regulations of the ICA, dating from 1989. Among the problematic aspects of the law are a lack of clear requirement for the segregation of fund assets; lack of regulation of investment advisers to the funds; lack of requirements for custodial supervision of the operation of the fund, and a lack of clear provision for valuation and pricing controls. These funds do not seem to enjoy the confidence of investors, many of whom prefer to invest funds domiciled in other jurisdictions. A draft of a completely new law, the Revised Investment Company Act, which has as its intention "to revise RA 2629 to provide the legal framework and environment for capital markets development through mutual funds" was originally proposed in 2001 but remains pending. Source: Cadogan Financial 2006. Establishing and maintaining investor confidence The key difference between these legal structures The most important factor in promoting the growth is in the form of governance.139 A fund formed as a of the asset management industry is probably investor company will usually have a board of directors. These confidence. Ensuring investor confidence requires a directors have a fiduciary duty to the shareholders of focus on several aspects: the company and it is they who appoint the manager Clear legal definitions of the legal form of the fund, of the fund and the custodian to provide the services the primary duty of fund managers and custodians to the fund, and who oversee the contractors' con- to act in the interests of fund investors, and the duct of the fund's business. Their duties therefore requirements for third-party supervision of the fund are more wide-ranging than those of an ordinary manager's conduct of the business of the fund. The company director. choice of legal structure in which funds are permitted In a fund formed as a trust, the fund trustee has to be formed--whether as companies, trusts, or con- a fiduciary duty to the investors in the fund, who tractual pools--will partly depend on the legal envi- are technically beneficiaries of the trust. The trustee ronment within which they are created. Generally, has the task of overseeing the conduct of the busi- countries with common-law systems will specify funds ness of the fund by its manager and of protecting formed as trusts, while civil-code system countries investors' interests. Generally, fund law or regulation enable a contractual form; both legal systems enable will also require the manager of the fund to act in the funds to function as companies (Table 6.9). interests of fund investors. A fund formed under a contractual pool has nei- ther directors nor trustees--and hence no entity with a fiduciary duty to the fund's investors, unless such TABLE 6.9 Governance Structures of Mutual Funds duties are placed upon the manager and the custodian Economy Corporate Contractual Trust of the fund by law and regulation. It is thus extremely important to specify these duties when drafting the China Y laws and regulations governing such funds. Generally Indonesia Y Y Rep. of Korea Y Y this is done by requiring both manager and custo- Malaysia Y Y dian to act in the interests of the fund investors and Philippines Y by making the custodian responsible for overseeing Thailand Y Hong Kong (China) Ya Ya Y the manager's conduct of the business of the fund.140 Singapore Ya Y Y In those East Asian legal environments where the fund has a trustee (Hong Kong [China], Singapore, Source: Cadogan Financial 2006. and Malaysia), the law and precedent of the trust Note: a. There may be limitations on the ability to publicly offer these funds--trusts are the main vehicle for domestic retail investment. ensure that the trustee will automatically act as 144 East Asian Finance a watchdog for investors' interests. Where funds common mutual fund or a unitized pension scheme, are contractual (as in China, Indonesia, Korea, and is the most crucial of all administrative operations Thailand) the duties of the custodian as a watchdog and, if not done correctly, it will damage at least need to be defined in the law. Although these duties one category of investor through dilution. This is are hinted at in China, Indonesia, and Korea, none what happened with the collapse of fixed-income of these three countries has laws that give sufficient funds in Korea in 1999 (Box 6.2).142 Since then, how- strength to custodians' responsibilities, so investors ever, with the adoption of mark-to-market valua- are weakly protected at this level. Thailand's law tion for all funds (from July 2000), regulations have provides for a trustee that is separate from the cus- been strengthened, including to enhance investor todian, whose duties are solely supervisory. In the protection, and this is helping to restore investor Philippines, funds are corporate in nature and there- confidence. fore the role of the fund directors should be similarly Disclosure to investors is crucial. Potential and emphasized. existing investors should receive statements that give Rights of investors. It is also crucial for investor clear and fair information, including the prospectus, confidence that the rights of investors be well defined, fund performance, fund charges and prices, and particularly rights to redemptions and voting where audited accounts. Here, comparability is key. relevant. One reason why problems have arisen in China, whose asset-management industry is very new, is giving increasing attention to protecting Indonesia is that the Capital Markets Law of 1995, investor interests. Investors have the right to sue which has been under review for some time, does not managers and/or custodians if incomplete disclosure adequately specify the nature of a contractual fund leads to investor losses. Unit holders also have the and the rights of its unit holders. Although both cor- authority to determine, for example, the renewal or porate and contractual funds are allowed under the early termination of fund contracts, increases in com- law, only contractual funds have come into existence pensation to fund managers and custodians, and the in Indonesia, partly because they are less cumber- replacement of fund managers and custodians. The some and quicker to create for managers and more recently passed Securities Investment Fund Act em- flexible and more tax-efficient for investors than phasizes the interests of investors more strongly corporate funds.141 The law and regulations have been than previous legislation. based on the assumption that the corporate type of In Malaysia, the supervisory authority has em- fund would be the key form, and as a result have phasized the relationship between disclosure policy focused on specifying these funds, rather than the and the development of the mutual fund industry contractual form. This is a key weakness, since while and, as mentioned earlier, has adopted disclosure- an investor in a corporate fund buys shares and has based regulations to protect investors. There are also all the rights of a normal shareholder, a purchaser self-imposed regulations, with investment compa- of a unit in a contractual fund has no rights unless nies asking actuarial firms to assess their financial these are specified in law and regulation. situation and inform investors. Ensuring equitable treatment of incoming, ongoing, Hong Kong (China), as an international financial and outgoing investors in open-ended funds through center, strongly enforces transparency by disclosing valuation, pricing, and issue and redemption rules is the monitoring process, the information on the important. Equitable treatment of fund investors is underlying funds, the relationship with the prime bro- a key principle that should be established in fund kers, and the independence of the valuation agents. laws, but often is not. Fund managers can favor one Singapore, too, has taken a disclosure-based approach set of investors over another, for instance by tipping under which investors make decisions based on infor- off favored clients (often institutional clients or clients mation disclosed by fund managers, rather than using of affiliates of the fund manager) when they know the merit-based approach (under which the regulators net asset values are likely to fall, so the latter can determine the suitability of the securities being made redeem their holdings. It is also important to set available to the public). Singapore also gives investors rules that ensure investors are treated equitably in the right to require any reasonable information to the valuation of assets and pricing of funds. make decisions. The Monetary Authority of Singapore The valuation and pricing of units or shares in has published disclosure checklists based on the In- any collective investment scheme, whether it is a ternational Organization of Securities Commissions Strengthening the Investor Base 145 BOX 6.2 Collapse of Fixed-Income Funds in Korea in 1999 Korean mutual funds suffered a massive crisis of confidence immediately following the collapse of the Daewoo chaebol in July 1999. Managers and investors in fixed-income funds (within Daewoo and outside), which had been substantial holders of Daewoo debt, realized that Daewoo's default would reduce the value of their investments and rushed to re- deem their shares. Funds were left with Daewoo bonds (and other corporate paper that could not be reliably valued, given the turbulent conditions of markets), which could not be sold to raise the money needed to pay investors redeeming their shares. This series of events exposed endemic flaws in both the regulatory system and in the way the funds had been managed and sold. In particular, cost-based asset valuation had allowed unit prices to be manipulated to offer yields apparently higher than those available in the market, and high-pressure sales of units by brokers, coupled with "promises" of no loss, misled investors into believing that potentially volatile assets were no more risky than bank deposits. These factors--coupled with weak supervision, which had allowed asset-management companies to break the law--had led to a rapid increase in assets under management. The government had to step in to prevent a systemic collapse of the bond market, and suspended those funds that had invested high percentages of their assets in Daewoo paper. Investors were only permitted to redeem in stages, according to a schedule that would permit an orderly disposal of assets. This bailout was costly to taxpayers, and fund management and securities companies, who were the principal owners, were compelled to contribute substantially to the cost of shoring up the industry. The Korean government has since undertaken significant reforms to strengthen the mutual fund industry. From July 2000, mark-to-market valuation was adopted for all funds. Legislation, which had previously been fragmented, was sub- stantially revised. The Indirect Investment Asset Management Business Act was promulgated in 2003 to consolidate and integrate the asset-management industry and enhance investor protection. Nonetheless, investor confidence took time to be restored. Source: Cadogan Financial 2006. (IOSCO) standards and issues a stop order if the funds, which are exposed to market volatility, have checklists are violated. been sold as equivalents to bank accounts but with Disclosure requirements vary across the region. a better return. (This has been the case in China, They are strong in China, Hong Kong (China), Korea, Indonesia, and Korea in the past.) Then, when inter- Malaysia, and Singapore, and weakest in Indonesia est rates rise and fund unit proceeds fall, investors and the Philippines. panic, and the result is a wave of redemptions lead- Specific rules governing investment advice are ing to liquidity problems. needed, to ensure that proper information and advice To avoid such problems calls for clear catego- are given. An area in which regulation is often weak-- rization of funds; disclosure of associated risks; and as in China and Indonesia--is the regulation of the a rigorous regulatory regime, covering both firms distribution channels that sell investment funds to the and individuals that sell funds to investors, that sets public. Thailand has recognized this weakness and ad- standards for responsibility, competence, and the dressed it in revised and new regulations issued in the conduct of business. In this context, the mutual late 1990s. While laws usually categorize fund shares fund industry's code of ethics and standards of pro- or units as securities, thus making their public offering fessional conduct are an important part of investor subject to laws or regulations governing securities-- protection, particularly in view of the regional trend or sometimes specific funds--it is common to find to replace the traditional merit-based method of that individuals who sell funds are only required to regulation with the market-based method. A code of have the bare minimum of knowledge or expertise. conduct upholds the discipline of market players, Responsibility for their conduct and accountability especially the asset-management companies. It sets for their failures are often also poorly defined. out general principles and minimum standards of Unambiguous rules are needed to identify different practice to guide the conduct of managers in the best categories of funds, and steps should be taken to interests of investors and the asset-management avoid any portfolio abuses. Often longer-term bond industry. In some jurisdictions, such as Hong Kong 146 East Asian Finance (China), Indonesia, Singapore, and Thailand, codes of Throughout the region, banks are playing a strong ethics and standards are issued by the supervisory or- and growing role in mutual fund sales. In both China ganization. In countries such as Korea and Malaysia, and Indonesia, for instance, banks are estimated to they are issued by an association of investment- sell 80 percent or more of the funds. Clearly, banks management companies as a form of self-regulation. that have nationwide distribution facilities and exist- In the Philippines, no explicit code of conduct exists. ing customer bases are ideally placed to facilitate fund sales. Dominance by any one distribution channel Adopting a supportive policy environment enables that channel to extract more fees, commis- While enhancing investor confidence is a key element, sions, and other benefits from fund managers who the development of the industry can be further facil- need the access it provides. This will not necessarily itated, or deterred, by government policies. benefit consumers, who are likely to end up paying First, government commitment to develop the for this through higher annual sales fees or higher mutual fund industry and ensure consistency of annual management fees. policies is fundamental. A reputable, flourishing Distribution channels are not easy to diversify, industry is unlikely to exist when the environment however. One possibility is to professionalize finan- for developing funds--and their returns--is subject cial advice. If successful, this effort can give rise to a to arbitrary governmental or regulatory decisions. new distribution channel: firms whose sole business Second, to succeed, mutual funds must be fiscally it is to undertake this activity. competitive with other products. Tax efficiency is an To professionalize financial advice entails creating important factor for investors comparing the merits a regulatory regime that governs those agents who are of an investment fund with those of a more familiar permitted to give financial advice, the qualifications bank account or savings account, or saving through they must hold, and the way in which they conduct insurance or a pension fund. If investment funds are their business (including finding out about clients' to thrive, they must face taxation no higher than on financial positions and needs). It also requires stan- direct investment in the same underlying assets or in dardized disclosure of commissions and fees received. competing savings vehicles. Under such a regime, agents who sell funds--whether Third, establishing a competitive environment within banks or outside them--are constrained to while maintaining adequate entry and capitalization identify their clients' needs and meet them in the best requirements can help to diversify products and way possible at a stated cost that can be compared enhance demand. As noted above, product diversity with that of other providers. This strategy is currently in mutual funds is still limited in most countries in being considered in China. The provision of financial the region. Since retail investors' goals and risk pref- advice is only weakly regulated in many of the region's erences vary widely, the ability to develop and offer economies; Singapore and Hong Kong (China) are products that match diverse target levels of risk and the strongest in this respect. return is crucial for the growth and health of an asset- Hong Kong (China) and Singapore have gone management industry, even a mature one. A good further in facilitating the development of the asset example is the recent introduction of the retail hedge management industry. They have structured gov- fund in Hong Kong (China). In countries where the ernment policy so as to encourage fund managers to range of collective investment products is still rela- manage funds from their own domiciles, even if those tively limited, such as China, Indonesia, Malaysia, the funds are in other countries. In Singapore, for Philippines, and Thailand, the range of instruments instance, the Central Provident Fund (CPF) has that funds can invest in needs to be broadened-- committed itself to outsourcing the investment subject, clearly, to considerations of availability and management of more than S$20 billion of its own liquidity, as mentioned earlier. Enhancing competi- assets, and has also allowed its members to select tion among fund-management companies is likely certain unit trusts to back their own funds (a simi- to provide an important impetus to the development lar concept to the 401k plan in the United States). of new products and growth of the asset-management industry. Ensuring regulations are enforced Professionalizing advisory services can help in In ensuring the stability, and hence ultimately the establishing competition in distribution channels. sustained development, of the asset-management Strengthening the Investor Base 147 industry, rules and regulations must be equitably regulators to focus on easily identifiable but low- enforced. The high-profile actions of the New York impact regulatory breaches such as small arithme- Attorney General in 2003, and subsequently of the US tical errors or gaps in reports or late filings, than Securities and Exchange Commission, in relation to to address much more fundamental problems the U.S. mutual fund scandals associated with late such as incorrect or manipulated asset valuation, trading and market timing, illustrate the importance which may require high-profile and difficult deci- of equitable enforcement for the stability of the in- sions to be taken. But it is the latter that cause greater dustry: not only were the companies concerned damage to investors, and imposing only small fines fined and made to compensate investors, but they and modest sanctions for such behavior can bring also suffered a loss of business. the regulations themselves into disrepute. There are many examples of a reasonably ade- Several factors may deter regulators from tack- quate regime being poorly enforced, including one ling substantive issues. The first is a lack of industry from Indonesia, where a problem with fixed-income knowledge and experience, which is natural given funds was in part exacerbated by poor enforcement that regulators are often drawn from civil-service (Box 6.3). backgrounds, but difficult to address unless salaries A further factor to bear in mind is that regulators can be made sufficiently attractive to attract practi- need to enforce rules in a manner proportionate to the tioners to work in regulatory agencies. The second is damage that a breach of the rules is likely to inflict a lack of protection from legal action; this can be on investors' interests. Admittedly, it is easier for addressed by laws granting suitable immunity. Third BOX 6.3 Enforcement Failure: Fixed-Income Funds in Indonesia Fixed-income funds under management in Indonesia fell by 73 percent in 2005. Up until then, with declining interest rates, sales of fixed-income funds had been rising strongly, and at the end of 2004, near the peak of the market, they represented nearly 82 percent of total assets under management (valued on a cost/accrual basis). The rise reflected a steady increase in unit values, but also the fact that interest from fixed-income funds was taxed less heavily than bank interest. Funds were therefore offering higher interest than banks (whose staff sold most of these funds to investors). It is also likely that the sales persons implied that these funds were actually like bank accounts (where capital was not at risk) and with a better rate of interest. New regulations by Bapepam, applicable from January 2005, required fixed-income funds to mark their assets to market rather than valuing them on a cost/accrual basis. In January, the largest fund-management company moved its fixed-income funds to a mark-to-market valuation system and suffered major redemptions as investors panicked when the value of the units fell. From March 2005 onward, as the Indonesian economy and currency came under some pressure, the Bank of Indonesia raised interest rates. Those funds that marked to market saw their units fall in value and sustained substantial redemptions as a result. Those funds that did not do so--despite the regulatory requirements--saw continuing sales. However, particularly strong interest rate hikes in August and September and the level of redemptions on funds finan- cially forced more funds to move to mark-to-market valuation, since they could not sell their bonds at the valuations at which they had been holding them. Overall, the values of fixed-income funds fell by 85 percent during the year, with around 60 percent of the fall due to redemptions and the rest due to reduced valuations. The new mark-to-market regulations that were applicable from January 2005 were demonstrably not met by many mar- ket participants during much of that year. It did not appear that any regulatory action was going to be taken until, follow- ing the redemption crisis, a Parliamentary committee instigated an investigation of four market participants by the regulator, which subsequently fined them for various infractions. No action appears to have been taken yet against other market par- ticipants that may also have failed to comply. Thus not only was enforcement late, it may also have been uneven. There is a danger that this will reduce market participants' confidence and hence their commitment to the market. It is probable that a high level of redemptions from fixed-income funds would have occurred anyway, had the regu- lators forced market participants to comply with mark-to-market requirements beginning in January, since the funds had been misrepresented as secure investments since neither sales agents nor investors understood fixed-income funds and their associated risks. To avoid the same problems in the future, it is important that sales agents' competence be improved, along with fund categorization and disclosure, particularly of the risks associated with the investments. Source: Cadogan Financial 2006. 148 East Asian Finance is a fear of political interference or of displeasing through a pension scheme and who have longer- powerful market participants who could separate term investment horizons (since they cannot usually them from their jobs.143 A high turnover of regulatory redeem until retirement) into the market, providing staff, who are commonly rotated across departments, greater stability to the mutual fund industry. ministries, or agencies, or headhunted by the market, The securities regulator usually regulates the activ- can also reduce an agency's capacity to retain the nec- ity of selling securities, which usually include fund essary knowledge and expertise and thus the capacity units or shares. But it can be difficult for the securities to regulate effectively. regulator to exercise effective oversight over sales of A final factor that can seriously compromise effec- mutual funds by banks, which are regulated by the tive enforcement is fragmented regulatory mandates. central bank or banking regulator. This problem arises Often the regulatory responsibilities for mutual funds, particularly where the securities license is held by the unitized pension systems, and unit-linked life assur- bank itself, rather than by a separate subsidiary that ance are divided between several regulators, on the is directly licensed by the securities regulator and assumption that the products offered are very dif- therefore answerable to it. ferent. This does not allow economies of scale to be Korea, the third-largest market in the region, has reaped by asset managers who may have to obtain recently overhauled various laws governing asset several licenses to operate different funds that are management and in 2003 introduced a single Indirect essentially the same, and who may even need to create Investment Asset Management Business Act, with different companies. If, for example, mutual funds the goal of enabling all asset-management activities exist, and are generally regarded as well regulated, it to be regulated at an equivalent level by unifying all would make sense to use them as investment com- asset-management-related regulations. Hong Kong ponents for defined-contribution pension schemes, (China) and Singapore have taken similar actions. as happens to varying degrees and in varying ways in Regulation remains fragmented in China, Malaysia, Hong Kong (China), Malaysia, and Singapore. This and the Philippines, but Indonesia is combining its would enable managers to pass on the benefits of non-banking and securities regulators. In Thailand, economies of scale to investors by lowering manage- the Securities and Exchange Commission regulates ment costs. It would also bring savers who hold units both mutual funds and provident funds. Developing Sound 7 Markets for Risk Sharing With the right policy For derivatives and securitization in turn, this chapter reviews key developments and the state of markets, and outlines the main ele- and regulatory environ- ments of policy to help strengthen and expand these markets. ment, derivatives and securitization-- Derivatives Markets instruments and Derivatives--developed within an appropriate framework of solid mechanisms for risk product design, regulation, and sound market infrastructure-- can play a very important role in allowing market participants to transfer and risk manage and transfer risks to those better able and willing to bear sharing--can offer them (Box 7.1). substantial benefits. BOX 7.1 Main Features of Derivatives Markets Derivative instruments are financial contracts whose value depends on, or derives from, underlying assets (such as securities or commo- dities) or indexes. Derivatives can be classified into two types: for- wards and options. Forward derivatives include mainly forwards, futures, and swaps. Option derivatives include options, caps, floors, and all financial instruments with embedded options such as callable bonds, mortgage-backed securities, and collateralized mortgage oblig- ations. Option instruments have a payoff pattern that is non-linear and asymmetrical--that is, the change in value of the derivative is not in the same proportion and may not be in the same direction as the change in the value of the underlying asset or index. (In this fea- ture, option instruments are unlike forward derivatives, whose value changes in the same direction and proportion as the value of the underlying assets.) Borrowers can use derivatives to reduce funding costs, efficiently alter the proportion of fixed- to floating-rate debt, enhance the yield on assets, modify the assets' payoff structure to correspond to the firm's market view, and, perhaps most importantly, to transfer mar- ket risk, or hedge. Thus, for example, commodity futures provide clear benefits for commodity producers: knowing future prices allows them to make more efficient economic decisions. Foreign-exchange deriv- atives provide invaluable hedging tools to corporations and even to smaller firms engaged in international trade, allowing them to match the currency composition of their assets and liabilities. (Continued) 149 150 East Asian Finance BOX 7.1 Main Features of Derivatives Markets (Continued) At the same time, as experience has shown, derivatives also carry risks. In the large literature on the advantages and disadvantages of derivatives markets, concerns arise especially in the areas of leverage, corporate governance, and accounting and transparency, as well as about counter-party and potentially systemic risk in unregulated markets. An analogy may help to illustrate the trade-offs: car insurance can be regarded as a derivative product whereby the insur- ance company makes a future contingent payment in the case of car accidents in return for a premium paid now by the car owner. By pooling the risk, insurance can lower the cost to car owners and generate a profit for the intermediary. However, the protection might induce some motorists to drive more recklessly and ultimately push up accident and pre- mium rates. Nobody would argue that economies would be better off without car insurance, which implies that the re- wards of derivatives outweigh the risks. Obviously, though, solid regulatory frameworks, strong risk management practices, and close supervision are indispensable. Derivatives can be traded on organized exchanges or in unregulated over-the-counter (OTC) markets. Commodity and equity futures, which can be standardized easily, are traded on the exchange. Given the variety of needs and speci- fications (size, duration, currency) in interest- and foreign-exchange derivatives, these tend to be traded over the counter, although recently benchmark securities have helped to standardize these products on exchanges as well. The main functions of the OTC market are to provide efficient financing and enable cross-currency hedging, as well as to transfer credit risk. This market remains dominated by a few large financial institutions, as well as inter-dealers; only 10 percent of the activity is attributed to non-financial institutions. The main functions of the ETD market are to hedge commodity-price risks and to redistribute equity-market and interest rate risks from issuers to investors. About half of the market is driven by institutional investors (with a strong international participation) and the other half is shared by retail investors, trading and securities firms, and some non-financial institutions. Major ETD markets report that about half of their volumes are trading-oriented and the other half are hedging- or arbitrage-related. Developments in East Asian derivatives Globally, exchange-traded derivatives (ETDs) markets since the financial crisis reached US$53 trillion in market value in 2004, nearly six times the market value of the OTC deriva- Global derivatives markets have grown extremely tives. Some 65 percent of the ETDs are equity futures quickly over the past decade or so. Globally, over-the- and options (both on the index and individual counter (OTC) derivatives markets have increased stocks), 26 percent are interest-rate derivatives (both tenfold over the past decade to reach US$248 trillion on short-term interest rates and long-term govern- in 2004 (Bank for International Settlements 2005). ment bonds), and 9 percent are commodity futures. The market value of these OTC derivatives is about Derivatives markets in East Asia have accounted US$9 trillion, although after netting arrangements for a sizable proportion of the global growth. Five have been taken into account, the actual value is esti- main derivatives products are traded in East Asian mated to be around US$2 trillion.144 Most of the OTC derivatives--more than 75 percent--are interest-rate markets (Table 7.1): products (mostly swaps). A much smaller propor- tion, about 12 percent, are foreign exchange prod- Foreign-exchange products, which are traded ucts, and about 10 percent are credit derivatives. in Tokyo, Singapore, and Hong Kong (China), The latter have been the fastest growing component, mostly in OTC markets. There are also offshore amounting now to about US$6 trillion. markets, mainly in Singapore, for minor and non- TABLE 7.1 Main Over-the-Counter and Exchange-Traded Derivatives Economy OTC-FX OTC-INT ETD-INT ETD-EQU Singapore 91.0 9.0 42.0 3.0 Hong Kong (China) 70.0 11.0 1.0 4.0 Rep. of Korea 10.0 1.0 13.0 50.0 Other East Asia 8.0 4.0 1.0 8.0 % of world total 15.0 1.8 2.1 3.7 Sources: BIS Triennial Central Bank Survey, 2004; WFE Annual Report and Statistics, 2005. Note: OTC: Over the counter. FX: foreign-exchange derivatives. ETD: Exchange-traded derivatives. INT: interest-rate derivatives. EQU: equity derivatives. Developing Sound Markets for Risk Sharing 151 convertible currencies (such as non-deliverable with a large participation of institutional investors forward instruments in the Chinese RMB). The and significant foreign participation. combined East Asian markets account for about Commodity derivatives. These have a long history, 15 percent of worldwide trading (Table 7.1, col- especially in China, where the soybean futures umn 1). contract at the Dalian Commodity Exchange is the Interest-rate derivatives, where East Asia accounts third largest derivatives contract in Asia and is for less than 2 percent of worldwide trading on the among the world's 20 largest derivatives contracts. over-the-counter market and slightly more than In addition, wheat, rubber, gold, and oil futures 2 percent of the ETD market (columns 2 and 3). are large and are mostly traded on Chinese (and There is a trend in the region toward ETD Japanese) specialist commodity exchanges. How- markets--for example, the Republic of Korea has ever, commodity derivatives account for less than recently moved its government-bond derivatives 10 percent of the turnover of the exchanges. onto the exchange. Tokyo and Singapore are the Credit derivatives, which are among the fastest- two dominant locations that trade mostly Japanese growing products, and especially credit default yen and U.S. dollar swaps (OTC) and futures swaps, which account for about half of this OTC (ETD). Local fixed-income derivative markets have market. It is estimated that about 10 percent of been developed only recently and remain small. the worldwide US$6 trillion OTC market in credit Equity derivatives, which have seen the most rapid derivatives is located in Asia, mainly in Tokyo and growth, often doubling every two or three years Hong Kong (China). (column 4). These are mostly ETD markets, with Korea and Hong Kong (China) showing the most Thus, derivatives markets are already important impressive recent growth. Index futures as well in the region, although still limited to a few jurisdic- as options are the most widely traded products, tions (Table 7.2). TABLE 7.2 Derivative Products and Turnover Hong Kong Economy China Indonesia Korea Malaysia Philippines Thailand (China) Singapore Index Futures n y y y n n y y Options n n y y n n y y Options on futures n n n n n n n y Stock Futures n n n n n n y y Options n n y n n n y n Currency Futures n y y n n n n n Options n n y n n n n n Interest-rate Futures n n y y n n y y Options on futures n n n n n n n y Bonds Futures n n y y n n y y Options on futures n n y n n n n y Commodities Futures y y y y n n n y Options on futures n n n n n n n n No. of products traded 1 3 9 5 0 0 6 9 Notes: China: Zhengzhou and Dalian Commodity Exchange amd Shanghai Futures Exchange. Indonesia: Jakarta Futures Exchange and Surabaya Stock Ex- change. Korea: Korea Stock Exchange and Korea Futures Exchange. Malaysia: Malaysia Derivatives Exchange. Philippines: Manila International Futures Ex- change was closed. Singapore: SGX-DT. Thailand Futures Exchange plans to open in 2006. n = does not exist. y = exists 152 East Asian Finance As noted, the growth of derivatives in the region down on derivatives after the crisis and merged has been led by transactions in the formalized ex- three exchanges into the Malaysian Derivatives Ex- changes. The formalized exchanges in the region can change, which trades commodity and equity futures be divided into three tiers. In the first tier are those in roughly equal proportions and has doubled its trad- of Hong Kong (China) and Singapore, which offer a ing volume over the past two years. China experienced large variety of interest, foreign exchange, equity, and major problems in the 1990s and closed 27 of its 30 ex- commodity products. The second tier comprises ex- changes (Box 7.2); it currently only allows com- changes in Korea and Malaysia. The Korean Futures modities future trading, which is expanding rapidly. Exchange has become the largest exchange in the The third tier of exchanges, in Indonesia, the world in terms of trading volume and was created in Philippines, and Thailand, trades very few derivatives. 2004 by merging the Korean Stock Exchange (focused All three countries' markets allow banks to trade in on equity derivatives) and KOFEX (focused on fixed- OTC derivatives and have recently considered (re)in- income derivatives). The Futures Exchange offers nine troducing ETD markets. After serious losses during types of derivatives with relatively simple products, the financial crisis, Thailand has kept its offshore and low transactions costs, and very advanced information derivatives markets on a short leash, with OTC deriv- technology and Internet trading. Malaysia clamped atives trading in the range of US$30 billion in 2004. BOX 7.2 Failure of a Futures Exchange: The Shanghai Stock Exchange Several futures exchanges have failed because of weak clearing houses and poor margin systems. For example, the Hong Kong Futures Exchange went bust in 1987 after the stock market collapse, and the futures arm of the Moscow Stock Exchange failed in 1994. Less well known is the example of the Shanghai Stock Exchange (SSE). The SSE became the world's largest exchange when it traded 4 million government bond futures on one day (February 23, 1995), but then collapsed, when price manipulation caused more than US$10 billion in losses in just eight minutes. This case highlights many valuable lessons about the preconditions that need to be met for successful trading of derivatives. China established the Shanghai Stock Exchange in 1990 and in 1993 opened the trading of government bond fu- tures through 50 brokerage firms to the general public. The government bonds that were issued took the form of zero coupon bonds with three- to five-year maturities, some at variable interest rates that were adjusted discretely with so- called inflation subsidies, and they were settled with physical delivery--a choice that often caused shortages, because the open interest in futures markets far exceeded the physical amounts of outstanding bonds. In a short period, more than 30 exchanges opened up and more than 50 futures contracts were traded in a casino- like atmosphere. In 1994, hot money migrated from equity to futures markets for government bonds, which were traded mostly in Shanghai, but also in Beijing, Shenzhen, and Wuhan. New regulations and position limits were then announced by various regulators. On February 23, 1995, expecting a decision on the size of inflation subsidies for some illiquid bonds, a small brokerage owned by the ministry of finance, bet on a long position while the largest broker, Shanghai In- ternational Securities (SIS), took a short position. When information arrived on the subsidies, which would cause sub- stantial losses to SIS, they tried to corner the market by reversing their position to the amount of $26 billion in trading, exceeding limits by 20 times, violating rules and rigging prices. Illegal transactions continued over the next three months and the government then suspended all futures trading on May 18, 1995. The hot money then immediately flowed back to equity markets, which posted their largest gain of 31 percent on the same day. Three lessons can be drawn from this experience: · First, a sensible design of derivatives products is critical. At a minimum there needs to be a well-functioning and liquid cash market, in which risk management has been tested, volatility is within reasonable bounds, and both long and short positions can be efficiently traded. The establishment of each new derivative product focused on hedging has to have an economic rationale, rather than being purely for speculation. · Second, the market infrastructure at derivatives exchanges and clearing houses needs to be soundly developed. The governance of the exchange needs to set incentives for market participants to honor rules of conduct and the stabil- ity of the trading system, and only qualified investors should be permitted. · Third, transparent legal and regulatory structures as well as a level playing field are other important preconditions. Clear accountability for a lead regulator and for market participants needs to be established and the legal framework must support strict enforcement. Developing Sound Markets for Risk Sharing 153 The Thailand Futures Exchange, established in 2004, straints have been removed (as happened in the hopes to begin trading index futures in 2006 and is Chinese commodity and bond futures markets). actively considering introducing interest-rate deriva- Since many derivatives are settled in kind (rather tives. Indonesia has established the Jakarta Futures than cash), a sizable amount of underlying securities Exchange, and introduced equity index futures at the for settlement is also required. Many examples in Surabaya Stock Exchange in 2001. However, market developed markets have shown that large derivative infrastructure and investor interest are still nascent positions can be abused to "squeeze" the cash and trading volumes have remained very low. Finally, markets, if large and liquid benchmark securities OTC derivatives are allowed in the Philippines, but have not been established. Reports by IOSCO have the Manila Futures exchange was closed after irregu- pointed to the required coordination between cash larities in 1997. and derivatives markets. Since derivatives markets are still limited to a few How large should the relative liquidity in cash and jurisdictions in the region, the discussion below asks: derivatives markets be? As can be seen from Figure 7.1, such markets may have liquidity up to five times larger What key elements need to be put in place as than the underlying cash markets, as in Korea, for ex- countries consider further developing and broad- ample. The most liquid markets often use advanced ening their derivatives markets? information technology and have large online trading, Where do countries stand with respect to these small transactions costs, and significant participation elements? by retail investors. Further growth then appears to re- Is there an appropriate sequencing of markets quire movement along this corridor, with propor- and measures? tional increases in cash- and derivatives-market turnover. Segmented markets and access restrictions can re- Key elements of sound derivatives markets strict the liquidity and efficiency of markets. This To further develop the derivatives markets in East would suggest that in China, interest rates would need Asia, cross-country experience suggests the follow- to be fully liberalized, and the two segmented bond ing needs. markets integrated, before trading in government- bond futures can resume. More generally, as noted Cash markets earlier, in bond markets, the development of on-the- First on the list are efficient, liquid, and integrated run benchmarks can help foster liquidity. In addition, cash markets (for bonds, equities, commodities, and modern information technology, trading platforms, other assets) that are broadly determined by market and Internet trading often enhance liquidity. forces rather than by administered prices. Adminis- tered interest rates, segmented fixed-income markets, Suitable legal and regulatory framework and capital controls make it unlikely that interest- or In general, there are three reasons why financial in- foreign-exchange derivative markets can develop stitutions and/or financial markets need to be regu- successfully. If at all, they may develop offshore (as lated: to protect depositors, to secure the integrity of did non-deliverable forward markets for currency in payments, and to maintain financial stability (the last Singapore) or in parallel unregulated markets (OTC requires that possible contagion across markets be derivatives offered by conglomerates in offshore loca- limited). tions). In fact, as experience from previous crises Regulators in Anglo-Saxon based legal systems has shown, derivatives markets can create systemic argue that the existing institutional supervision of risk if the prices of the underlying instruments are banks obviates the need for any additional functional not market-determined. For example, fixed ex- regulation of derivatives markets; instead, markets are change rates have been undermined by short foreign- encouraged to develop self-regulatory organizations exchange-futures positions in Europe's Exchange to maintain their integrity. This approach appears to Rate Mechanism,145 as well as in Korea, Russia, and be consistent with the existing market structure in Thailand. And administered commodity prices and the United States and United Kingdom, where over- interest rates have invited speculation in derivatives the-counter derivatives trading is dominant and the that has often led to overshooting once policy con- market is highly concentrated among banks. By con- 154 East Asian Finance FIGURE 7.1 Liquidity Ratios in Equity Derivatives and Cash Markets Equity derivatives turnover 100,000 sno 5.1 line 1.1 line lliib$S United States 10,000 Germany U,revonrutsevitavired United Kingdom Japan Rep. of Korea 1,000 Brazil Hong Kong, China Singapore Australia Spain Indonesia 100 100 1,000 10,000 100,000 cash turnover, US$ billions Note: The figure shows the ratio of derivatives turnover to cash-market turnover in the leading equity markets. trast, in East Asia as in many emerging markets, trad- Hence regulators in these countries have adopted ing in exchange-based derivatives has seen very a more function-based approach to regulating de- strong growth involving a mix of banks and securi- rivatives markets, recognizing that such trading may ties firms, and institutional as well as retail investors pose higher risks for retail investors as well as for (Figure 7.2). systemic stability. Indeed, many regulators have ex- FIGURE 7.2 Participants in Key East Asian Derivatives Markets, 2004 banks securities companies institutional retail foreign Rep. of Korea FX futures Rep. of Korea bond futures Hong Kong, China equity options Rep. of Korea equity index options Hong Kong, China equity index options Rep. of Korea equity index options Hong Kong, China equity index options 0 0.2 0.4 0.6 0.8 1 Source: Hong Kong Securities and Futures Commission 2005 and Korea Exchange 2005. Developing Sound Markets for Risk Sharing 155 pressed a policy preference to channel derivatives standards of governance and accounting, and are re- trading away from the unregulated OTC markets quired to hold enough capital for their respective risk into regulated ETD markets--which have additio- positions. It is also important that intermediaries be nal safety cushions, since every trade requires a prior made accountable to deal with only "fit-and-proper" cash deposit for margins that limit leverage. clients who understand the characteristics and risks Thus, one of the key elements of an appropriate of derivatives. legal framework is appropriate regulation (functional Regarding the key elements of institutional in- and/or institutional), including self-regulatory orga- frastructure, the most important are good disclosure nizations. Experience has shown that exchanges that practices and accounting standards, including the have good powers of market surveillance and enforce- practice of mark-to-market valuation as required ment have been more effective at self-regulation than under IFRS accounting standard IAS 39. have trade or industry associations. Demutualized Finally, as regards market infrastructure, the exchanges (Box 5.5) are likely to be able to estab- single most important means to manage risk in de- lish the incentives for market participants to honor rivatives markets is to reduce exposure through rules of conduct and enhance the stability of the close-out netting arrangements, ideally using a cen- trading system. Strong coordination among regula- tral counterparty (CCP) that interposes itself be- tors (local authorities, securities regulators, central tween the counterparties to financial contracts that bank, and finance ministry) is critical to close any are traded in one or more markets. Such arrange- loopholes and ensure that rules are strictly enforced. ments were initially developed by securities ex- There is also a need to enact a derivatives law that changes and have recently been adopted in some protects netting arrangements (see below) in bank- OTC markets. ruptcies and enables effective enforcement. The benefits of netting can be very large; for To provide a level playing field between OTC and example, even bilateral netting by U.S. commercial ETD derivatives, capital rules for banks operating in banks has reduced credit exposure from derivatives the OTC markets need to be aligned with the margin by more than 80 percent. Indeed, the BIS and IOSCO rules that govern ETD derivatives markets. Other- recommendations for central counterparties, issued wise, the margin rules effectively put most ETD mar- in 2004, emphasize the significant benefits that can kets at a disadvantage. Taxes for all derivatives and be gained from a central counterparty by imposing related cash products also need to be harmonized, more robust risk control on all market participants since such transaction costs are an important driver and by achieving a multilateral netting of trades. of liquidity, changes in which can shift or even desta- However, because a CCP also concentrates risks, its bilize markets. Recently, for example, Korea began use requires effective risk controls, financial resources, taxing capital gains from derivatives (they were pre- and oversight, because a failure could spill over to pay- viously exempt) at the same rate as cash-market ments and other settlement systems. Therefore a CCP transactions. This has led to a better balance between is expected to have several safety cushions, including cash and derivatives trading. adequate capital and effective margin rules. Countries Before allowing the trading of derivatives, both in the region are quickly adopting these recommen- long and short positions should be allowed in the dations and several CCP arrangements have been underlying cash market. As discussed in Chapter 5, announced, most recently in the merged Korean Stock for bond markets, repurchase agreements (repos) Exchange. In principle, these recommendations can need to be established, as does the development of be applied to the over-the-counter markets as well, securities lending, which is often combined with and the industry association, the International Swaps margin trading. Short positions may be limited to and Derivatives Association (ISDA), has been active in hedge net long positions, but they are critical to de- developing master agreements for bilateral close-out velop liquidity and to reduce the likelihood that netting. Major banks have thus far opposed multi- derivatives will be used to substitute for short cash lateral netting through a CCP because that would re- positions. quire them to post margins and hence increase their On the regulatory side, it is also important to en- transaction costs. sure that market participants that intend to deal in Thus policymakers need to achieve a delicate bal- derivatives are licensed and trained according to high ance between the need for financial innovation and 156 East Asian Finance low transaction costs on the one hand, and reduc- ETD markets. To promote safety and soundness, ing the potential risks to financial stability on the the development of the more complex OTC prod- other. ucts should probably not be sought until a later stage Economies in the region are at various stages of (unless these products emerge spontaneously to meet development of the infrastructure needed for deriv- a need). Usually index futures are among the first atives markets (Table 7.3). products to be introduced, before options on in- In countries that have a considerable way to go in dividual assets. Subsequently, more tailored or in- developing these elements, it is also useful to think novative OTC-traded derivative products, such as about the appropriate sequencing of products and credit-default swaps, may be designed. Typically, the measures (Figure 7.3). intermediaries are banks, which should receive spe- In particular, as discussed above, experience sug- cific regulatory clearance and should support their gests there is merit in developing deep and liquid risk positions with adequate capital. Management of cash and repo markets first, followed by many of the counterparty-credit risk requires special emphasis, derivatives products that trade primarily on the which is typically facilitated through ISDA master TABLE 7.3 Status of Infrastructure for Derivatives Markets Rep. of Hong Kong Infrastructure China Indonesia Korea Malaysia Philippines Thailand (China) Singapore Market status Fixed-income benchmarks ( ) ( ) y y x y ( ) y Fixed-income liquidity ( ) x y ( ) ( ) ( ) y y Equity market liquidity y ( ) y y x ( ) y y Regulatory aspects Derivatives law x x ( ) ( ) x ( ) y ( ) Securities lending ( ) ( ) y x x ( ) y y Accounting standards ( ) ( ) ( ) y ( ) ( ) y y Exchanges Clearing and settlement x x y ( ) x ( ) y y central counterparty ISDA netting option x y y y y y y y Demutualized exchange x x y ( ) x ( ) y y Taxes Tax harmonization x y y ( ) x x ( ) y Transactions costs ( ) x y y ( ) ( ) y y and information technology Investor base and ( ) x y ( ) x ( ) y y non-bank financial institutions Number of best-practice 1 3 10 5 1 2 10 11 elements Sources: Information on derivatives law is from individual jurisdictions; only Hong Kong (China) currently has a distinct derivatives law. Securities lending in- formation is as reported in Chapter 5 above, showing restrictions on short selling in Malaysia and the Philippines and very little activity in Thailand and In- donesia. Central counterparty information is from industry sources and the ADB, showing adequate functioning only in Hong Kong (China), Singapore, and Korea. International Swaps and Derivatives Association Inc. (ISDA) netting opinions have been issued for all countries but several countries still have issues to resolve in this regard. Data on taxation were obtained from Price-Waterhouse-Coopers, "Taxation on Financial Derivatives in East Asia," which shows small stamp duties in effect in Hong Kong (China) and Malaysia and value-added tax being applied in China, the Philippines, and Thailand. Transaction costs in the bond market are obtained from ADB and additional market information. Information on the institutional investor base reflects the data and discussion in Chapter 6 above, which shows weakness especially in Indonesia and the Philippines. Notes: y denotes best practice; ( ) denotes progress on existing deficiencies; and x denotes major problems. Fixed-income liquidity indicators and benchmarks, as discussed in Chapter 6 above, show weaknesses in China (segmented markets), Hong Kong (China) (small local currency issuance), and Indonesia, the Philippines, and Thailand (very limited medium- to long-term benchmark issues). Equity market indicators reveal thin markets in Philippines, Indonesia, and to a lesser extent Thailand. Developing Sound Markets for Risk Sharing 157 FIGURE 7.3 Stylized Elements and Sequencing of Derivatives Markets Development Market Regulatory Institutional Market Other status aspects infrastructure infrastructure Cash Liquid, Good efficient, accounting, integrated Mark to market; markets in underlying; benchmarks Repo Effective Taxes; level margin trading; playing field securities cash = repo = D lending allowed ETD Derivatives IAS 32, IAS 39: Exchange; Law; SRO full disclosure capital, margins, function; platform, links. Intermediary Design CCP; licensing close-out net; ISDA master; enforcement OTC OTC license; Regulatory approval--CP credit risk; swaps, IR,FX Source: Author. agreements, the use of counterparty-credit ratings, monitoring large risk positions across multiple and the posting of collateral. counterparties. Research suggests that while OTC markets offer Therefore, many policymakers have encouraged more flexibility, ETD markets are better at sup- an early development of ETD markets on a level play- porting financial stability.146 Traditionally, foreign ing field (making sure that regulations and taxes do exchange and longer-term interest rate derivative not discriminate against ETD markets), with best- products have evolved on OTC markets, whereas practice risk management systems, especially single- equity and commodity products have been listed on clearing counterparty systems. In addition, regulators ETD markets. More recently, however, many shorter- are tightening OTC licensing requirements and step- term interest rate and foreign exchange contracts ping up the enforcement of investor suitability rules have also been listed in ETD markets. From a policy in OTC derivatives markets. perspective, governments can create a level playing field for both markets through guidelines affecting Securitization taxation and risk management. (In practice, many OTC markets are less regulated, less transparent, Securitization, which entails transforming illiquid less liquid, and less expensive than ETD markets, assets into securities that can be issued and traded on and this can create unhelpful incentives for the faster securities markets, can provide another important development of OTC markets.) From the perspec- mechanism for sharing risks, particularly credit risks tive of systemic risks, most accidents in derivatives (Box 7.3). The process of securitization can some- markets have occurred in the OTC markets, as the times involve the creation of derivative products, result of limited transparency and the difficulties of such as mortgage-backed securities, which are option 158 East Asian Finance BOX 7.3 Principles of Securitization Securitization deals generally have three characteristics: pooling effects from a wide variety of receivables, isolation from originator, and a structure with tranches that have different risks and pricing. Risk transfer can be achieved by either true-sale structures, in which ownership is passed on to a special-purpose vehicle (SPV), or by so-called synthetic securi- tization, whereby the originator can issue on its own balance sheet. The SPV, in turn, issues one or more debt securities-- asset-backed securities--whose interest and principle repayments depend on the cash flow coming from the underlying assets. Any kind of receivable can be securitized in principle, but investors are only interested in receivables with stable and foreseeable future payment streams. Thus assets that have been transformed in this manner include residential mort- gages, auto loans, credit-card receivables, leases, and utility payments. There are three types of basic underlying receiv- ables: asset-backed securities, such as credit-card payments; collateralized debt obligations, such as loan payments; and mortgage-backed securities, both residential and commercial. Types of Securitization Asset-backed securities broadly defined Asset-Backed Securities Mortgage-Backed Securities Collateralized Debt Obligations Narrowly Defined Residential mortgage-backed securities Collateralized loan obligations Credit-card receivables Commercial mortgage-backed securities Collateralized bond obligations Leasing receivables Trade receivables Consumer loans The "originators" are usually corporations or financial institutions. The key to asset securitization is the separation of good assets from a company or financial institution and the use of these assets as a backing for high-quality securities that appeal to investors. Such separation makes the quality of the asset-backed security independent of the credit- worthiness of the originator. The originator (bank or company) selling the assets will normally continue to service them and hence will continue to derive the servicing revenues. Although most originators are top-quality banks and corpora- tions, some weaker borrowers have been able to employ their good assets to access capital markets that would other- wise have been closed to them. For corporations, asset securitization provides a new and potentially cheaper form of financing. For financial institutions that have successful loan programs but face capital constraints, securitization is a means of removing assets from the balance sheet and of freeing up capital to support further lending. Asset securitiza- tion can open a new avenue for funding--one that can enable a financial institution to achieve a good match between its assets and liabilities. bank or special purpose vehicle investors company pool of loans asset-backed or receivables securities derivatives, and, as discussed below, it can also require ment, and liquidity risk in return for higher yield. the availability of simpler derivative instruments to Because the deals are usually large and have high hedge some of the risks associated with securitization. credit ratings, the securities tend to be liquid and For investors, securities offer yields that exceed may be actively traded in secondary markets. The those on comparable corporate bonds and provide great majority of asset-backed securities are held by diversification into a different form of investment. institutional investors. In East Asia, a major share of Securitization therefore broadens the investor base these securities is held by commercial banks, but in- because it caters to wider set of risk/return appetites creasingly pension funds and insurance companies that are willing to bear incremental credit, prepay- are showing interest. Developing Sound Markets for Risk Sharing 159 Developments in East Asian securities (1999­2001), collateralized bond obligations and markets since the financial crisis collateralized debt obligations accounted for the bulk of the transactions, as securitization in Korea focused The market for asset-backed securities in the region-- on addressing the nonperforming loans of financial both the domestic and cross-border segments--has institutions and on refinancing the corporate bonds grown quite rapidly since 1999 and is becoming an that needed to be rolled over. The issuance of ABS important element in the overall development of the peaked at 50.9 trillion won in 2001. One such deal, securities markets. Securitization is being used for a Korea Asset Management Company's Korea Asset wide variety of purposes, ranging from facilitating Funding Ltd., 2000­01, was the first cross-border access to capital markets for small- and medium- securitization deal. The ABS market has also been size enterprises and the transfer of credit risk from used to provide funding for small- and medium-size banks to capital markets, to the transfer of both enterprises. For instance, the KOROmas Fund Ltd banks' and non-bank financial institutions' mort- transaction, completed in December 2001, raised gage loans to capital markets. US$300 million for this purpose through the is- Thus far, however, this market has been largely suance of a floating-rate note that was backed by confined to Hong Kong (China), Korea, Malaysia, and loans from 59 Korean companies. Payment guaran- Singapore. Thailand has seen only three securitization tee was provided by the Korean Development Bank transactions since 1997, although the government through a US$350 million credit facility (Box 7.4). has recently announced its first large future-flow During 2000­03, Korea's main issuers of asset- transaction to finance new government offices. Only backed securities were financial institutions and a few transactions have taken place in the Philip- credit-card companies, together accounting for pines, and none in Indonesia yet. In China in 2005, almost two thirds of the volume. As discussed ear- the government proceeded with two pilot transactions lier, during this period the government had stimu- in which two state-owned financial institutions-- lated domestic consumption and consumer credit China Development Bank and China Construction rose rapidly, leading to large-scale defaults and large Bank--were given approval to issue asset-backed losses for credit-card issuers and banks. As a result, securities. China Construction Bank launched an the volume of asset-backed securities declined in RMB 3 billion securitization transaction and China 2004. Due to the uncertainties that were created in Development Bank issued collateralized loan oblig- the market by the increase in credit-card delinquen- ations (CLOs) in three tranches amounting to RMB cies and a scandal at SK Global, investors in Korea 3 billion. As discussed below, to facilitate the launch now have a strong preference for short-term notes of these projects the Chinese authorities have had to over medium- and long-term asset-backed security issue provisional rules. instruments. (In 2004, about 73 percent of the trans- Outside of Japan, the largest asset-backed securi- actions had maturities of less than two years.) ties market in the region is in Korea. Securitization Issues of asset-backed securities in Hong Kong in Korea was facilitated with the passage of the Asset- (China) during 1997­2001 amounted to about backed Securities Act in 1999, covering most of the US$3 billion--or about 31 percent of the total legal and regulatory issues associated with securiti- US$9.7 billion issuance of such securities in the re- zation. In particular, the Act defined the term "asset- gion. However, there were no such transactions in backed securitization" and specified the three main Hong Kong (China) at all in 2002. Securitization ac- types of issuers in Korea: (1) a special-purpose com- tivities picked up in 2003 and gained further mo- pany; (2) a trust company under the Trust Business mentum in 2004 when the Hong Kong Mortgage Act; and (3) foreign companies specializing in asset Company issued the first-ever retail mortgage- securitization. In the same year, the Government also backed security in Asia, for US$3 billion (Box 7.5). passed the Mortgage-backed Securitization Company The latter enjoyed an exceptionally wide distribu- Act to foster development of residential mortgage- tion through 900 bank branches as well as the tele- backed securities. phone and electronic networks of 19 placing banks. Since then, the market for asset-backed securities Transactions initiated by real-estate-investment in Korea has grown rapidly (from 6.8 trillion won in trusts (REITs) have led to a pick-up in securitization 1999 to 26.1 trillion won in 2004). In the early period in Singapore. A recent example is the S$1.0 billion 160 East Asian Finance BOX 7.4 The KOROmas Fund Ltd. The US$300 million KOROmas deal is an emblematic transaction in which foreign capital financed small and medium firms in Korea. The KOROmas Fund issued three classes of notes for this purpose. US$285 million were issued in "A" notes, which have been rated BBB+ by Standard and Poor's, and have the backing of a credit facility of up to US$350 million by the Korea Development Bank (KDB). The junior "B" notes target Korean investors and are without KDB support, and the "C" notes are supported by the equity of the companies in the fund. Proceeds of the note sales were used to buy Eurobonds with warrants attached to a pool of 60­70 Korean enterprises valued at US$344 million. The participants were selected from among 400 companies, and there is a heavy technology bias among the group. Investors are essentially buying a collateralized bond obligation with the credit guarantee of KDB and the upside of the Korean companies in the Fund. Despite the involvement of the Korean government, the Korean firms will be paying a market rate for their funds. The deal is a landmark one that will serve as a blueprint for tying for- eign capital to companies that have difficulty in accessing international funds, given their size and concerns about their creditworthiness. The group that assembled the deal believes that there could be considerable interest in similar deals in China and Singapore. Source: Dalla 2005. Emerald Asset Limited, which raised funds through Malaysia to develop the asset-backed securities mar- securitization to refinance its existing loans and to ket in close collaboration with the private sector and invest in new property projects. Large financial in- key market participants. It established an Asset Secu- stitutions are increasingly using synthetic transac- ritization Consultative Committee, consisting of tions for risk management (Box 7.6). prominent experts in their respective fields (legal, In Malaysia, as part of its plan to develop the cap- accounting, tax, financial institutions, and other ser- ital market, the government made concerted efforts vice providers) to update and amend the asset-backed through the Securities Commission and Bank Negara securities guidelines. Arising from the Committee's BOX 7.5 The Bauhinia Program Bauhinia MBS Limited (Bauhinia) is a bankruptcy-remote special-purpose company established by the Hong Kong Mort- gage Company (HKMC) for the issuance of mortgage-backed securities (MBS) under the Bauhinia program. HKMC pe- riodically sells mortgage portfolios to Bauhinia, which then packages the loans into mortgage-backed securities (MBS) of different series for issue to investors. As a result of the availability of a "master" prospectus, the issuer only needs to prepare a simpler prospectus supplement to accompany the issue of new MBS. This allows a high degree of flexibility, enhances efficiency in issuing the MBS in different series, and facilities the design of specific structures to meet the vary- ing needs of investors. Thus mortgages purchased from different sellers have been collateralized and both floating- and fixed-rate notes have been issued under the program. Payment of principal can be structured in different ways to meet investors' needs. For example, Class A-1 of the MBS issue in October 2003 was insulated from repayment and prepayment of the underlying mortgage pool in the first three years. This is particularly suitable for investors who prefer a stable return on their investments. The key features of the program are: · The issues can be in different currencies to meet the demand of both domestic and overseas investors. · The interest payable on the coupon date is predetermined and known to the investors. This facilitates the trading of the MBS and hence enhances their liquidity in the secondary market. · HKMC guarantees the timely payment of principal and interest of the MBS. As HKMC is a public-sector entity, all of these MBS notes qualify for 20 percent capital-risk weighting and are treated as liquefiable assets under the Hong Kong Banking Ordinance. Source: Hong Kong Mortgage Corporation, 2006. Developing Sound Markets for Risk Sharing 161 BOX 7.6 Singa Secured Assets Singa Secured Assets is a special-purpose vehicle based in Singapore and established by the Development Bank of Singapore (DBS), which is one of the largest banks in Asia and the largest in Singapore, providing a wide range of com- mercial banking and financial services. Singa Secured Assets will support an asset-backed short-term note program col- lateralized by loans and bonds originated by DBS. The proceeds of the notes are to be used to purchase the designated assets. Singa is bankruptcy-remote and its obli- gors will be selected to ensure that its rating remains A-1. Uniquely, the pool will include no more than ten obligors at any one time, and the rating will be based on the weakest rating in effect at any time among them. A S$2 billion com- mitted facility will be provided by DBS. The program is the first rated asset-backed notes program originating in Singa- pore and the first securitization deal in the country to be rated by Standard and Poor's. It provides a flexible alternative form of funding for a book of high-quality assets. DBS has pioneered the development of structured notes in Singapore through several landmark property transac- tions. This deal represents a further advance in the country's debt markets by creating an innovative product for Singa- pore investors, including retail investors. Source: Standard and Poor's 2005. recommendations, Malaysia's revised Guidelines on of these securities was launched by Cagamas and the Offering of Asset-backed Securitization Transac- backed by a RM1.9 billion portfolio of residential tions by Licensed Institutions are designed to facili- mortgages serviced by the pensions of retired public- tate the participation of banking institutions in the sector employees. In addition to being the first do- ABS market. The two key features of the prudential mestic RMBS transaction, it is also the first transaction standards are the spelled-out capital requirements involving government assets and the first true securi- and the transparent criteria. These have enabled the tization by Cagamas.147 banking institutions to undertake primary and sec- Cross-border securitization transactions in the ondary roles in ABS issuance without the need to seek region have also grown, although not as fast as case-by-case approval from Bank Negara Malaysia, domestic securitization (Table 7.4). The volume of and have set up the framework to foster the develop- cross-border securitization grew from US$1.2 billion ment and growth of the ABS market. The outstanding in 2000 to US$4.2 billion in 2002, mainly because volume of ABS stood at RM14 billion in mid-2005, of large credit-card transactions from Korea. With up from less than RM1 billion in 2001. Several inno- growing consumer debt and the slowdown in credit- vative transactions took place in 2004, including card loans in Korea, the volume of cross-border the first credit-card transactions and the first resi- transactions originating in that country dropped dential mortgage-backed securities (RMBS). The first sharply in 2003 and 2004, leading to a smaller issuance TABLE 7.4 Cross-Border Securitization Transactions 2000 2002 2003 2004 US$ US$ US$ US$ Origin millions % millions % millions % millions % Hong Kong 300.0 25.1 0.0 0.0 419.9 35.0 566.3 18.1 (China) Rep. of Korea 769.0 64.4 3,222.9 78.4 652.9 54.4 1,553.8 49.8 Singapore 125.0 10.5 290.1 7.1 127.8 10.6 1,002.0 32.1 Malaysia 0.0 0.0 600.0 14.6 0.0 0.0 0.0 0.0 Cross-national 33.3 2.8 141.3 3.4 374.5 31.2 0.0 0.0 Total 1,194 100 4,113.0 100 1,200.6 100 3,122.0 100 Sources: Moody's Investors' Service, IMF IFS. 162 East Asian Finance the maturity of their assets and liabilities. For in- FIGURE 7.4 Composition of Cross-Border vestors, securitization can offer yields exceeding those Securitization Deals on comparable bonds, while providing an opportu- nity to diversify a fixed-income portfolio. And gov- ernments are increasingly looking to securitization as others RMBS real estate a means of funding for infrastructure projects. In- global CLO equipment lease deed, the importance of further developing the secu- credit card CMBS auto ritization markets is widely recognized in the region. CBO/CDO/CLO Hence this section looks at the following questions: 5,000 What are the key elements necessary for securiti- sno 4,000 zation and what are the remaining issues to be addressed? 3,000 milli$S To reduce some of the risks commonly entailed U2,000 in different forms of securitization, does it make sense to sequence the types of securitization that 1,000 are undertaken? 0 How will the adoption of Basel II--which most 2000 2002 2004 countries in the region plan to adopt over the next few years--affect securitization activities by banks? Securitization requires that certain legal, regula- in aggregate. At end-2004, total cross-border issuance tory, and accounting elements be in place. First, it re- in the region amounted to US$3.1 billion, with Korea's quires legislation that allows for the creation, transfer, share of cross-border securitization having dropped and perfection of ownership interests. Contractual from 68 percent in 2001 to just under 50 percent in restrictions on the types or terms of financial assets 2004. During 2003 and 2004, issuance from Hong that can be transferred for the purposes of securiti- Kong (China) and Singapore picked up and accounted zation will affect securitization itself. Such restric- for much of the remaining 50 percent. tions are common in all the East Asian markets, except The composition of cross-border asset-backed generally in Hong Kong (China) and Singapore. securities transactions in East Asia has changed sig- Obligor notification or consent requirements, like nificantly since 2002 (Figure 7.4). In that year, con- the need to obtain specific regulatory approval be- sumer finance, mainly for credit cards and vehicle fore transferring assets, would also affect the effi- purchases emanating mostly from Korea, accounted ciency with which securitization transactions can for the major component, but by 2004 more than take place. Rules also need to address the taxation two thirds of total transactions were related to real and gain-recognition events that may be triggered estate, both residential and commercial. The only by the transfer of assets to a securitization vehicle. consumer-related category in 2004 was auto loans, Taxes and duties can reduce the incentives to secu- which accounted for about 10 percent of the total ritize. It is also generally important to have various transactions. Collateralized debt obligations and types of default, foreclosure, and/or repossession collateralized loan obligations were also important. remedies that may be exercised at the individual level by the servicer or other administrator of the securitization transaction. Key elements needed for securitization While the details will vary among jurisdictions, a Asset securitization can benefit many players in the generic requirement for securitization is to be able to region's economy. For corporations, securitization ensure a true sale--that is, the irrevocable transfer of can provide a new and potentially cheaper source of assets to an insubstantive special-purpose vehicle funding. For many financial institutions that have (SPV) to which the asset seller has no ties of owner- few tools for managing risk, securitization can pro- ship or control.148 (Funding for the asset purchase is vide new funding that enhances their ability to match provided by the sale of public or private securities to Developing Sound Markets for Risk Sharing 163 third-party investors.) The transaction must with- level, hence bringing the assets back onto the books stand any legal claim in bankruptcy against the asset of the originator. Also, the fair-value measurement seller (bankruptcy remoteness). Another important of asset-backed securities poses some challenges set of issues relates to the legal framework governing in the absence of consistent transacted prices and the creation, maintenance, and operation of special- quotes, and the difficulty of these challenges is com- purpose vehicles themselves. The most basic pre- pounded by illiquid bond markets. requisite is for the governing legal framework to Based on these key elements for successful securi- permit SPVs to issue securities evidencing ownership tization, Table 7.5 provides a broad assessment of the or beneficial interests in pooled assets, rather than a feasibility of undertaking a wider range of domestic general claim against the entity itself. In addition, it securitized deals, for both local and offshore inves- is generally desirable to limit taxes on the income of tors in the region. special-purpose entities and to avoid subjecting them China, Indonesia, Korea, the Philippines, and to burdensome licensing or other regulatory require- Thailand are civil-law jurisdictions. All of them have ments. In most cases, securities issued by an SPV introduced, or plan to introduce, laws that permit must also provide for the dependable subordination the creation of securitized transactions recognizable of claims. by international standards.149 In particular, the laws Finally, depending on the originator's objectives, will allow for the creation of special-purpose vehi- the balance-sheet effects and accounting treatment cles, which otherwise would not generally be permit- may influence the incentives to securitize and affect ted. But except in Korea, where the relevant laws are the structure of the securitization transaction. The well established and actively used, the enacted mea- key consideration in this regard is to structure the sures have yet to be tested either by a large number asset sales in a manner that achieves non-recourse of deals or in conditions of stress or challenge. In- sale treatment and asset de-recognition for balance- donesia permits certain transactions under authority sheet purposes. International accounting standard granted to Bapepam, the principal securities regula- IAS 27 lays out the principles under which an entity tor. In certain civil jurisdictions, the legal framework should consolidate another entity; interpretation currently applies only to transactions originated by SIC 12 of this standard focuses on the consolida- financial-sector intermediaries. Thus it may exclude tion of special-purpose entities; and IAS 39 deals transactions that involve financial claims or assets with the recognition and de-recognition of finan- owned or controlled by insurers or by industrial or cial assets and liabilities. The crux of the matter is similar concerns. It may also exclude similar trans- whether the transfer of assets in an asset-based se- actions where current or future claims are due to curities transaction is a true sale so that the assets wholly-owned financial substantive subsidiaries of should be taken off the balance sheet (de-recognized). insurers or industrial concerns. Private transactions Based on IAS 39, the sale will constitute a true sale completed in China in 2003­05 used the provisions if the originator has surrendered its control over of new legislation on companies and trusts. How- the assets and the transferee has obtained the ben- ever, these provisions will not facilitate the creation efits of the transferred assets (the principle of the of widely distributed securities. "substance over form" approach). Also at issue is The three common-law jurisdictions--Hong the treatment of the special-purpose vehicle (SPV) Kong (China), Malaysia, and Singapore--have most by the originator. Originators may have to consol- of the elements of law that are typically associated idate the SPV that they in effect "control." There is with securitized transactions in advanced markets a concern that the SPV would need to be consoli- involving existing or future claims originated by dated with the originator, thereby defeating the financial intermediaries. However, certain future purpose of de-recognizing the assets in the first claims (such as credit-card receivables) that cannot place. Overall, the new accounting rules are more be specified in ways expected by current law may stringent on the removal of assets from the balance be seen as problematic by investors or third-party sheet of the originator; the intended objective of mono-line insurers. transfer of assets may not be achieved, and even if Malaysian common law supports securitization. assets are taken off the balance sheet, there is a pos- Rules setting out general parameters for securitiza- sibility of consolidating the SPV at the originator's tion were first published only in 2001, but sales of 164 East Asian Finance TABLE 7.5 Status of Key Elements Needed for Securitization Creation, maintenance, Sale, assignment, or other conveyance of assets by and operation of special- originators to securitization vehicles purpose vehicle Other Legal framework Restrictions Default and Restrictions on for creating, on types or foreclosure Legal and securitization transferring, terms of and/or regulatory vehicles to and financial Taxation repossession impediments issue multiple perfecting assets that and gain at level of e.g., Taxation or tranches ownership can be recognition individual bankruptcy licensing with varying Economy interests transferred issues assets remoteness requirements characteristics China 1­2 1 1 1 1 1 1 Indonesia 2­3 2 2 2 2 2 2 Rep. of Korea 5 4 3­4 4 5 5 5 Malaysia 5 4 4 3­4 4 4 5 Philippines 2­3 2­3 1­2 2­3 2­3 2­3 2­3 Thailand 3-4 3 3­4 3­4 2­3 4­5 2­3 Hong Kong 5 5 4 5 5 5 5 (China) Singapore 5 5 5 4 5 5 5 Source: Arner and others 2006. Notes: Score 1 (lowest) to 5 (highest). Scores such as 2­3 represent an intermediate appraisal between two given levels. These split scores are intended to re- flect degrees of uncertainty as to commercial outcomes. There are contractual restrictions as to the transfer of financial claims in all review markets, except generally in Hong Kong (China) and Singapore. The table includes no appraisal of national accounting standards. It makes no attempt to summarize regula- tory restrictions on investors, which may have great impact on the early stages of market development. Such restrictions have traditionally been widespread, and only those in Hong Kong (China), Korea, and Singapore have been subject to relaxation since 2000, in relation to both the professional and retail segments. home mortgages began in the mid-1980s. Shariah- management instruments and the presence of reli- compliant transactions have been few to date; these able counterparties. Since the nature of the risks involve intricate structuring at all stages but are now can vary depending on the type of securitization, considered to be generally feasible, at least as single there may be an argument for sequencing the more deals. complicated forms of securitization in line with the Thus far, in many of the asset-backed transac- development of the requisite market players and tions that have been completed using source assets, derivatives markets. execution has relied on complex offshore private The risks generally associated with securitized structures written under English or New York law. products can be classified into three categories: credit, Except in Hong Kong (China) and Korea, the bulk structural, and legal (Table 7.6). of completed East Asian transactions both before Credit risks relate to the default risk on the pool of and since the legislative changes have been cross- receivables as well as to the possibility of default by border in nature, often as a device of structure to other parties involved in securitization. The most ensure the integrity of the asset sale, regardless of the important possibility to be considered is default by domicile of investors (often to meet the needs of the the underlying borrowers (such as car owners). While mono-line insurance providers). a small but predictable loan-loss ratio is manageable, the rating agency must carefully analyze and evalu- Sequencing to manage risks ate any factors that might trigger an escalation in de- While securitization has strong potential benefits for faults. Over-collateralization and third-party-credit originators and investors and can be an important guarantees are often used to reduce these risks. Credit means of transferring risk, it also carries risks of its risks associated with other parties can involve service- own, which in turn require the development of risk- performance risks: once a pool of assets has been Developing Sound Markets for Risk Sharing 165 TABLE 7.6 Types of Risks in Securitization Transactions Structural risks Credit risks Market Liquidity Operational Legal risks Pool of receivabl Interest rate risk Balance-sheet liquidity risk Agency risk General treatment Other partie Reinvestment risk Prepayment risk Commercial law Service performance ris Basis risk Market-based liquidity risk Tax law Swap counterparty risk Exchange rate risk Primary market Regulatory law Secondary market Enforceability of claims securitized, some entity, usually the originator of the ments, prepayments from the underlying mortgages assets, must continue to collect principal and inter- are often redirected to different classes of investors. est and pass on payments on a timely basis, and The best-known structure for accomplishing this service-performance risk arises from the possibility redirection is collateralized mortgage obligations. that the servicer will fail in these tasks. Proper screen- In this structure, the principal payments from the ing and monitoring of services, as well as the ability underlying mortgages are used to retire different to choose an alternative servicer if needed, can miti- classes of debt on a priority basis according to speci- gate the service-performance risks. Another form of fied terms. credit risk is swap-counterparty risk. This arises Interest rate risks arise when the payment char- when an interest or currency swap is part of the deal, acteristics of the underlying assets do not match the and it can be minimized by choosing a counterparty needs of investors. For example, if assets are leases, of high credit quality. Many asset-backed securities which are essentially fixed-rate loans, the cash flows are guaranteed, to relieve the investor of the burden may be unsuited to banks that prefer floating-rate of analyzing a complex structure. In some transac- assets. One way to bridge the gap is for the special- tions, swap-counterparty risk is covered in the finan- purpose vehicle to enter into a fixed-floating interest cial guarantee. rate swap that allows investors to receive a market- Sovereign risk is most evident when the under- based interest rate. This can be important for many lying assets are in one country and investors are in investors whose cost of funds is also based on short- another. The sovereign entity can interfere with cross- term rates. border cash flows through taxes, exchange controls, The risk of an exchange rate devaluation can arise or other measures. This risk can be mitigated using when the assets underlying an issue are denominated an offshore special-purpose vehicle and a foreign in a currency different from that in which the investors guarantor, or by capturing foreign-source cash flows, receive their returns. Some asset-backed securities or specifying an independent jurisdiction to govern contracts provide for an increase in local currency the agreements. payments to offset any decrease in the currency's value. Structural risks relate to market, liquidity, and op- Alternatively, a currency swap may be used to trans- erational risks. Market risks in turn, include prepay- form the local currency cash flows into known pay- ment risk, interest rate risk, and exchange rate risk. ments in say, U.S. dollars or Japanese yen. Prepayment risk arises when payments are made Liquidity risks mostly refer to the inability to sell in excess of the scheduled principal payments on a assets in secondary markets and the need to hold loan. When borrowers can refinance at cheaper rates, them until maturity. it generally means that investors must reinvest at Legal risks relate to commercial, tax, and regula- lower rates. That is why repayment risk often implies tory laws and their enforceability, as well as various interest rate risk as well. This risk is most relevant for operational risks. As discussed above, one of the mortgage-backed securities, since this is where pre- major issues in securitization is to be able to ensure payment can have the biggest impact on the present that the special-purpose vehicle is remote from value of forgone cash flows. To mitigate the prepay- bankruptcy. For this purpose, the SPV must be in- ment risk for investors who prefer long-term invest- sulated against the bankruptcy of the originator, and 166 East Asian Finance vice versa. Should the originator experience finan- Derivative instruments can also play an important cial difficulties, the SPV must still be able to perfect role in alleviating credit, structural, and legal risks its security interest in the assets and obtain full con- alike. For example, options can be added to cover spe- trol over cash collections. cific operational risks. Credit enhancements are Other legal issues include the legal, accounting, common tools to mitigate credit risk. They include and fiscal status of the asset transfer (is it a true sale?) limited recourse--a complex derivative instrument and the form of the SPV. whereby the originator is obligated to repurchase Figure 7.5 summarizes the main mechanisms securities under certain conditions. The most com- that could typically be used to mitigate credit and mon market risk in mortgage-backed securities structural risks in a more complex tranched securi- is prepayment risk. This is often hedged through tization deal, say involving not only credit risks but interest rate futures and options, which are also also foreign-exchange risks and interest rate risks. As useful to reduce basis risk and reinvestment risks. is evident, dealing with and reducing these risks Swaps (foreign exchange derivatives) are commonly effectively requires many different market players. used to reduce the exchange rate risk from securi- Arguably, one of the most important roles in tized products. risk mitigation is played by credit-rating agencies. In sum, interest rate futures and options (traded These agencies issue ratings based on their analysis on an exchange or over-the-counter), repurchase of asset portfolios, the legal structure of the trans- agreements, credit derivative instruments, and for- action, the credit quality of the originator and the eign exchange swaps are common derivative tools trustee, the cash-flow structure, and counterparties. that are used in various securitized products. Unless Given the complexity involved, rating agencies play these market tools are available, risks are often sub- a particularly important role in structured finance. stantially higher in securitized products. Thus, in FIGURE 7.5 Mechanisms to Mitigate Credit and Structural Risks in More Complex Securitization A credit rating agency evaluates credit risk/deal structure, assesses third parties, and issues ratings first loss provider subordinated pool performance owner investors guarantor originator servicer interest and principal guarantor sells assets 3 2 may add more assets senior Investors 1 over collateral special purpose vehicle (SPV) liquidity reserve cap or collar swap fund fund provider counterparty mitigates credit risk mitigates market risk through derivatives (e.g., interest and FX swaps) Source: Adapted from Giddy. Developing Sound Markets for Risk Sharing 167 promoting securitization, it is important for coun- dardized Approach in other cases, banks are required tries to keep in mind the need to also develop the to use the same approach for securities business that derivatives markets. they have chosen to use for calculating their capital re- In fact, effective risk management for securitized quirements for credit risk in their banking services products requires many components of the legal and overall. regulatory infrastructure that is necessary for broader Under the Standardized Approach, securitiza- derivatives markets. Therefore countries should con- tion exposures are assigned a risk weight according sider developing the derivatives markets in tandem, to their public external rating, and unrated expo- moving toward the more complex forms of securi- sures must be deducted from capital. There are five tization as the derivatives markets become better risk buckets for exposures with long-term credit rat- developed and more complete. For instance, wide- ings, ranging from 20 percent151 for exposures rated spread mortgage-backed securitization and the dif- AA- or better to 350 percent for those rated BB+ to ferent means of tranching debt can benefit from the BB-. A deduction from capital is required when the availability of strong credit-rating services as well as rating is inferior to BB-. There are three exceptions the existence of interest rate futures and options. At to this general treatment: present, as noted above, interest rate futures are avail- able only in Hong Kong (China), Korea, Malaysia, Unrated most-senior tranches may receive the and Singapore. average risk weight of the underlying exposures, subject to supervisory review. Implications of Basel II for securitization Exposures in a second-loss position (or better) in Because securitization is a relatively recent pheno- asset-backed commercial paper programs will re- menon it is not explicitly covered by the Basel I ceive the greater of 100 percent and the highest Accord, which dates from 1988.150 Indeed, besides risk weight assigned to any of the underlying in- being used for liquidity purposes and for credit-risk dividual assets of the pool. management, securitization has been a major source Eligible liquidity facilities will receive the highest of regulatory arbitrage under Basel I, and this has risk weight assigned to any of the underlying in- prompted national supervisors to develop their own dividual assets of the pool covered by the facility regulatory standards. and a credit conversion factor depending on the Basel II introduces a differentiated regulatory maturity of the facility. framework for securitization exposures to prevent regulatory arbitrage and to harmonize the varying Under the Internal-Ratings-Based Approach regulatory standards. Under Basel II, banks are re- (IRB), the securitization framework establishes quired to hold regulatory capital against all their three different methodologies with a hierarchy securitization exposures on the basis of the eco- among them: nomic substance of these exposures rather than their legal form. Exposures that banks retain, as sponsors The ratings-based approach (RBA) is compulsory of securitizations or as investors in the securitiza- for rated exposures or when a rating can be in- tions of third parties, are to a large extent treated ferred based on set requirements. The RBA assigns similarly. Securitization exposures may include pro- a risk weight to every exposure according to the viding credit-risk mitigation, investments in asset- external tranche rating. Risk weights range from backed securities, retention of subordinated tranches, 7 percent, which is the floor for AAA tranches, to liquidity facilities, or credit enhancement. a deduction for positions below BB-. In addition, Within the Basel II securitization framework, the the risk weights depend on the heterogeneity of so-called Standardized Approach to estimating capi- the underlying pool and the seniority of the con- tal requirements relies on the publicly available exter- sidered tranche. nal ratings provided by rating agencies, though banks The supervisory formula can be used if the ex- may also choose the alternative, Internal-Ratings- posure is unrated and the bank either is the Based Approach (IRB). To prevent banks that engage originator or has obtained permission from the in securities business from using the IRB when this re- supervisor. The supervisory formula assigns a cap- duces their capital requirements and using the Stan- ital charge on the basis of certain inputs to be 168 East Asian Finance calculated by the bank. These inputs are the cap- proach a bank adopts to credit risk, the less likely ital requirement prior to securitization (i.e., the it is to retain room for regulatory arbitrage (Fitch total amount of credit risk for the entire securi- Ratings 2005). tized pool), the effective number of assets, the Banks will face strong incentives not to retain un- weighted average loss-given-default of the under- rated tranches, as these are to be deducted from lying pool, the thickness of the tranche, and the capital. This should entice banks to have their se- subordination level. Thus, the formula relies com- curitization exposures rated--which may prove pletely on the bank's internal credit-risk inputs. difficult in some jurisdictions.152 It is also likely to The internal assessment approach is applied if encourage them to structure securitizations in a the exposure is to an asset-backed commercial way that minimizes the size of those tranches that paper (ABCP) program and meets certain con- attract the highest risk weights. ditions, for example that the exposure be equiv- A direct comparison of the Standardized and alent to at least investment grade at inception. Internal-Ratings-Based securitization regimes This approach, introduced due to the particular- indicates that banks using IRB may have an in- ities of ABCP programs, envisages the use of centive to specialize in less risky securitization internal assessments of the credit quality of the exposures, while those using the Standardized securitization exposure by the bank based on Approach will be inclined to specialize in riskier ratings-agency methodologies, if certain opera- exposures. For investment-grade tranches, banks tional requirements are met. using IRB will benefit from base-case IRB risk weights that are only about 60 percent of those ap- In all other cases, the bank must deduct the expo- plied to banks using the Standardized Approach.153 sure from its assets. Banks using the IRB approach thus have a greater Securitization is one of the critical markets in incentive to hold highly rated tranches (7 percent which the adoption of Basel II may have a significant risk weight for AAAs), than do banks using the impact. This is because: Standardized Approach (20 percent risk weight for AAAs). However, for tranches rated BB and Basel II aims at better aligning credit-risk capi- BB-, banks using the Standardized Approach tal requirements to economic risks. It will re- would be more efficient holders (with a risk weight duce regulatory arbitrage opportunities through of 350 percent) than those using IRB (425 percent securitization. The more sophisticated the ap- and 650 percent). Dealing with 8 Growing Linkages Across Markets New instruments, growing The global landscape in the financial sector has undergone major changes in recent years. Technological innovation, deregulation, linkages across financial and liberalization are blurring the traditional separation between segments through deriva- banking, insurance, and securities markets. tives and securitization, Financial intermediaries now offer products that partly resem- ble those traditionally offered by other intermediaries. In many and the rise of financial countries, for instance, insurance companies are allowed to offer conglomerates that provide short-term deposit-like products. Some new types of securities an array of services are products, such as credit derivatives, in practice bear many of the characteristics of an insurance product. And the securitization of blurring the traditional traditional forms of credit (such as mortgages, credit-card receiv- separation between ables, and commercial loans), and the proliferation of increasingly sophisticated ways of building, repackaging, and trading risks banking, insurance, and have weakened the distinction between equity, debt, and loans. securities markets. These The development of new products is giving rise to new forms developments entail of linkage across intermediaries and markets (Table 8.1). Finally, competition has encouraged different types of financial challenges for risk intermediaries to merge, giving rise to large conglomerates that monitoring, regulation, provide a broad range of services across the financial segments. The number of financial conglomerates--firms linked through com- and supervision. mon ownership and operating across different segments of the financial system--has grown rapidly over the past decade. In 1995 about 40 percent of the 500 largest financial firms in the world were conglomerates, but by 2002 this percentage had risen to 60. In East Asia, as discussed in Chapter 4, most economies allow banks to engage in securities (underwriting, dealing, and broker- ing all kinds of securities and all aspects of the mutual fund busi- ness); insurance (underwriting and selling insurance as a principal and as an agent); and real-estate business (investment, develop- ment, and management). Hong Kong (China) and the Philippines have the most permissive regimes, allowing any commercial bank to conduct securities, insurance, and real estate business. All other economies in the region allow banks to conduct businesses in other segments of the financial system subject, in some cases, to restrictions such as the need to establish subsidiaries and affiliated companies to engage in securities and insurance business. In- donesia and the Republic of Korea, for instance, allow banks to deal in securities and insurance through subsidiaries, but do not permit real-estate activities.154 169 170 East Asian Finance TABLE 8.1 Risk Transfers Among Banks, Insurance Companies, and Capital Markets Risk type Direction of risk transfer Credit risk Market risk Insurance risk Banks to insurance Bank equities and bonds Bank equities and bonds Insurance on bank property, companies Trade credit insurance legal liability, etc. Insurance provided to borrowers Asset-backed securities, Insurance companies writing to facilitate loans credit-default swaps, options and buying bonds portfolio CDOs, financial with embedded options Newly introduced insurance, guarantees, residual (e.g., callable bonds) e.g., for operational or value insurance, other political risk forms of credit insur- ance, and surety bonds Insurance companies Letters of credit Liquidity Hedging of embedded op- Catastrophe bonds to banks and other facilities tions in portfolios of life, capital market insurance and pension investors products Source: Bank of England Financial Stability Review, 2001. Note: Items in bold italics are the newer links. ABS = asset-backed securities. CDO = collateralized debt obligations. CDS = credit-default swap. Following the global trend, the East Asian coun- dated supervision, the information disclosed by tries have seen a rapid increase in the number and banks, securities firms, and insurance companies, or importance of financial conglomerates. Of the 200 any other type of entity belonging to a financial largest financial firms in the region, 111 are con- group, may underestimate the risks faced by these in- glomerates, accounting for 80 percent of the total as- stitutions as well as by the conglomerate as a whole. sets of these firms (only in Thailand does the presence More generally, the rise of conglomerates, the of financial conglomerates appear to be smaller-- growing linkages across market segments, and the there the ten largest conglomerates account for only blurring of distinctions among some of the products about 40 percent of the total assets).155 of different financial intermediaries pose challenges to risk monitoring, regulation, and supervision. Su- pervisors face difficulties in classifying some of the Trends and Issues in Supervision new products under the traditional categories of Few countries in the world are fully prepared to su- banking, securities, or insurance. Indeed, practition- pervise financial conglomerates on a consolidated ers now increasingly treat loans, securities, and in- basis. According to the Financial Sector Assessment surance polices as part of a continuum of products Program undertaken by the International Mone- that do the same thing: price risks. Risks become tary Fund and World Bank, only one in four of the more difficult to monitor not only because the link- 80 countries that were assessed between April 1999 ages have become more complex across financial and June 2005 were fully compliant with Basel Core segments or because the financial institutions have Principle (BCP) 20 on consolidated supervision. become larger and more complex, but also because As discussed in Chapter 4, this is an area where the these institutions and linkages through instruments East Asia region has also been found to be rela- span an increasing number of jurisdictions. tively weak.156 Traditionally, most countries have regulated and Without proper consolidated supervision, a fi- supervised their financial intermediaries through nancial conglomerate or any of its entities may be- multiple institutions, including the ministry of fi- come vulnerable to financial distress, due to double nance and the central bank, as well as specialized su- counting of capital, excessive connected lending, pervisory agencies such as banking, securities, and large intra-and extra-group exposures, and conta- insurance commissions. Some countries have estab- gion problems or conflicts of interest among entities lished additional agencies to oversee particular market of the group. Moreover, in the absence of consoli- activities such as derivatives, to supervise particular Dealing with Growing Linkages Across Markets 171 types of intermediaries (such as credit unions, mort- intermediaries and market segments; to better as- gage banks, thrift companies, or pension funds), or sess the real and potential impact of industry- and to deal with consumer-protection issues in the fi- market-wide issues, such as market turbulence, that nancial industry. affect the financial system; to better understand the Over the past 20 years or so, an increasing num- cross-sectoral nature of the business of financial con- ber of countries have started to examine how they glomerates; to more easily develop policies toward regulate and supervise financial intermediaries. the risks affecting a financial conglomerate as well as Recently a rapid transition has taken place toward its single entities; and to use a consistent approach so-called unified or integrated supervision, in which to monitoring similar financial products and ser- a single agency is responsible for supervising the en- vices, regardless of what type of financial institution tire financial system. Just five years ago the U.S.-style provides them. institutional structure--with at least one supervisor Thus the advantage that is seen in having a single for banks, one for insurance firms, and one for secu- or unified supervisor is that it can reduce problems rities firms--prevailed in more than 50 percent of of regulatory arbitrage,157 gaps in regulation and su- countries worldwide. But by the end of 2004, 60 per- pervision,158 lack of coordination between supervi- cent of countries had adopted either the model of a sory agencies, and weak accountability of supervisory single supervisor for the financial system or that of agencies (the unified supervisor becomes account- a partially unified agency in which two of the main able for its statutory objectives). intermediaries in a country are supervised by one Further arguments can be made in favor of unified entity. supervision, such as the maximization of economies In East Asia at present, the prevailing model is one of scale resulting from merging two or more of the of multiple supervisors in which at least one agency existing supervisory agencies. Economies of scale are supervises banks, another oversees securities firms, likely to arise from the move to unified management and a third the insurance companies. Jurisdictions and the adoption of a unified approach to standard with multiple supervisors include China, Hong Kong setting, authorization, supervision, enforcement, (China), Indonesia, the Philippines, and Thailand. and a single set of central support services. Further, Korea and Singapore, at the other extreme, have sin- the consolidation of human capital can increase ef- gle agencies responsible for supervising the entire fi- ficiency by permitting management to direct the nancial system. best people to the most critical situations. Integrated supervision can also reduce the amount of informa- The Pros and Cons of tion that financial intermediaries need to report to Unified Supervision supervisory agencies, as the unified supervisor be- comes the only authority that requests information Given the global trend toward unified supervision from financial intermediaries. and the interest that some East Asian countries have At the same time, several arguments can be made expressed in moving toward unified supervision, against moving to unified supervision. this section examines: First, a mega-regulator may become excessively The advantages and disadvantages of having single bureaucratic in its procedures and slow to react to versus multiple supervisors; and emerging problems. Second, the effectiveness of su- The international experience of moving to unified pervision may be compromised if a new integrated (single) supervision. agency fails to develop a consistent framework of regulation and supervision for the financial sector. Countries that have adopted unified supervision While a certain degree of harmonization of supervi- have done so in the belief that a single supervisor can sory practices among the banking, insurance, and be more effective than multiple supervisors in mon- securities supervisors is desirable to reduce regula- itoring the soundness of individual financial insti- tory arbitrage, it is important to recognize that the tutions as well as the vulnerabilities of the entire particular characteristics of each industry require financial system. In particular, they believe that uni- specific regulations. It should also be noted that if fied supervision allows them to better understand the supervision of financial markets is poor under and monitor risk transfers among different financial separate entities, it will still be poor under a unified 172 East Asian Finance regime, unless weaknesses in regulation and supervi- also be achieved through memoranda of understand- sion are effectively addressed. Finally, if the process ing that formalize arrangements for the exchange of merging is not managed properly, it may result of information and policy coordination among en- in the departure of experienced personnel and the tities. And, in certain cases, a country's legal frame- demoralization of the rest of the staff, affecting the work may allow a supervisory agency to become the overall effectiveness of supervision during the tran- "lead" supervisor in key issues that involve one or sition period. more agencies, such as the resolution of a failing Table 8.2 summarizes the pros and cons of alter- conglomerate. native supervisory structures. For countries trying to improve communication and collaboration among Implementation Issues in Moving their different supervisors, integrated supervision to Unified Supervision may not always be the most appropriate means to achieve this goal. There are other effective ways, A recent World Bank survey of 14 countries found such as having senior policymakers from different that countries face several important obstacles dur- agencies meet regularly and share relevant informa- ing the transition from multiple to a single (or par- tion. Effective collaboration among agencies can tially unified) supervisor (Table 8.3). TABLE 8.2 Advantages and Disadvantages of Different Models of Regulatory Structure Model Advantages Disadvantages Unified supervisor Facilitates the supervision of financial con- The merger process may reduce supervisory effec- (either inside or outside glomerates on a consolidated basis. tiveness during the transition period and possibly the central bank) Allows better monitoring of issues affecting beyond. the entire financial system, as well as rapid It may undermine the overall effectiveness of super- policy responses. vision by not recognizing the unique characteris- Allows the development and implementation tics of the banking, securities, and insurance of a unified approach of regulation and industries. supervision across the entire financial sys- There are other schemes to achieve prompt infor- tem, reducing regulatory arbitrage. mation-sharing and collaboration among existing Strengthens accountability of supervisors. agencies. Maximizes economies of scale and scope, May only work in certain countries and may be more contributing to a better use of resources. suited for developed financial systems. Gains in terms of economies of scale may not be significant. Partially unified agencies Provides some economies of scale. Little chance of extracting synergies from different (agencies supervising Does not over-concentrate power. types of regulation. banks and securities firms, Less costly than having one supervisor for Cost still relatively high. banks and insurance each intermediary. Potential for culture clash between banking (pru- firms, or securities and Deals better with conglomerates than does dential) and securities (conduct) regulators within insurance firms) the model of multiple supervisors, pro- the one agency. vided the dominant intermediary in a con- May involve conflict among objectives within the glomerate is supervised by the agency. banking/securities regulator or between banking/ insurance regulators. Still requires coordination and cooperation, espe- cially if financial conglomerates are present. Potential for regulatory gaps, overlaps, and arbitrage remains. Separate supervisors Agencies will be better prepared to under- Difficulties in cooperation and information sharing (at least one for banks, stand the unique characteristics of the among different agencies. one for securities firms, business that they supervise. Difficulties in implementing consolidated supervision. and one for insurers) A system of checks and balances among Each agency may develop its own prudential rules, supervisors can be put in place. allowing the potential for regulatory arbitrage. High cost of regulation and supervision. Dealing with Growing Linkages Across Markets 173 TABLE 8.3 Major Implementation Issues Reported by Countries in Moving to Unified Supervision Problem Total agencies affected (%) Legal constraints (requiring amendment of financial sector legislation) 67 Departure of experienced personnel 60 Delays in integration of IT systems and infrastructure of merged agencies 53 Demoralization of staff of the merged entity 53 Lack of mission objectives and clarity in the newly merged institution 13 Budgetary problems (insufficient funds to complete the integration of agencies) 13 Source: de Luna, Martínez, and Rose 2003. Note: Countries included in the survey were Australia, Canada, Denmark, Hungary, Iceland, Korea, Latvia, Luxembourg, Malta, Mexico, Norway, Singapore, Sweden, and the United Kingdom. Legal constraints their responsibilities at least during the first three years of operation. This suggests it is important that The mission, objectives, powers, and scope of re- laws be updated before or shortly after a new agency sponsibilities of a new unified supervisory agency has been established, to avoid weaknesses that may need to be defined in law. Moreover, in accordance undermine its effectiveness and credibility. with best practices (as defined in the Core Principles for banking, securities, and insurance respectively), the law should also provide the staff of the new entity Departure of experienced personnel and with autonomy and legal protection for decisions demoralization of staff and actions that they make in good faith, and estab- An unintended consequence of the unification of su- lish a mechanism to ensure the proper accountability pervisory agencies has been the voluntary departure of the new entity. of experienced personnel from the merging institu- In most countries, the establishment of such an tions. Nine out of fourteen agencies reported that agency has required the review and amendment of a valuable staff had departed as a result of the uncer- large number of financial sector laws and regulations tainty created by the merging process. A related to enable the new entity to fulfill its functions effec- problem has been the demoralization of the staff of tively across the financial system. In fact, it is not the merged entities during and after unification. Half surprising that some countries such as the United of the surveyed agencies have been affected by this Kingdom have gone beyond amending their existing problem. Many staff viewed the unification process laws and introduced a single piece of new legislation with uncertainty, not just because of the possible re- that replaces a number of sector-specific laws. dundancies but because of the delays in configuring In East Asia, 10 of the 14 unified supervisory the definitive structure of the unified institution, ap- agencies surveyed said that they experienced prob- pointing or ratifying the new heads of departments, lems associated with an outdated or inadequate legal and setting the overall conditions of employment.159 framework, at least during their first three years of existence (Table 8.3 above). The problems they faced included legal ambiguity with regard to their Managerial issues sources of funding, ownership of assets, power to The process of merging two or more supervisory endorse treaties with foreign counterparts, power to agencies is a major managerial challenge because impose sanctions against market participants, and each of the agencies has its own identity and, in most power to issue and amend prudential regulations. In cases, a well-established organizational structure addition, in a few countries, the staffs of the unified and corporate culture. Moreover, each agency has its agencies were not legally protected and laws did not own approach to regulation and supervision, and op- specify mechanisms to ensure the proper account- erates with its own tools and procedures in monitor- ability of these agencies. These types of legal prob- ing a particular type of financial intermediary and lems affected the capability of the agencies to fulfill ensuring compliance with laws and regulations. 174 East Asian Finance The management challenge of merging a number agency rather than a process of integration. If not of different regulatory agencies should not be under- properly managed, such a situation may compro- estimated. If the unification process is not managed mise the quality of supervision of the remaining fi- appropriately, there is a risk that it can go off-track. nancial segments, since the new agency may focus its In addition to the loss of experienced personnel and resources on the dominant financial segment at the demoralization of staff mentioned above, several expense of the others. agencies reported additional problems. Some related In addition, several of the surveyed agencies to the difficulty of developing a comprehensive plan emphasized the importance of establishing a clear to conduct the merger, including integrating the in- framework that delineates the supervisory roles formation technology systems and other essential in- and responsibilities of the unified supervisor, the frastructure elements of the merged entities. Others ministry of finance, and the central bank, and of concerned the difficulty of achieving economies of communicating to the market the objectives, poli- scale by downsizing the number of departments and cies, and tools of the new institution. personnel of the merging institutions, even when Table 8.4 shows the time that the group of sur- there was a clear duplication of functions. Moreover, veyed countries took to complete the various key ac- two of the surveyed agencies faced budgetary con- tivities related to the merger of their supervisory straints, as well as various problems in defining their agencies, starting from when the decision to merge mission and overall objectives, business plan, and the entities was announced. On average, the activi- work program; organizational structure with clear ties took between one and two years. Respondents responsibilities for each unit; and responsibilities of from all the countries agreed that whenever possi- senior staff. ble, these types of activities should be carried out as rapidly as possible, so as to minimize the uncer- tainty for the staff of the merging institutions. Other issues If a country decides to adopt unified supervision, Respondents to the survey also pointed out that an it is important that its policymakers define exactly important risk of establishing a unified agency is what they are trying to achieve and how. An inte- that the approach of one type of supervisor may grated supervisory agency can take different forms. prevail over the others. This may happen when one Authorities may want to adopt either a partial scheme type of financial intermediary--usually commer- of integrated supervision (by merging only two of the cial banks--dominates the financial sector, or when main agencies) or a full one (by merging all supervi- one of the merging agencies--normally the bank- sory agencies and creating a single supervisor for the ing supervisor--has a disproportionate number of entire financial system). Moreover, authorities may staff, resources, and facilities, so that the merger want to grant the new agency either a full or only a appears to be a takeover of the smaller supervisory limited set of powers to regulate and supervise the TABLE 8.4 Average Time Taken to Complete Key Tasks in Moving to Unified Supervision Task Average time taken (years) Set the definitive organizational structure of the new merged entity 2.0 Set in the legal framework the scope of legal powers, responsibilities, and goals of the new regulatory agency 1.5 Set the strategic (business) plan of the new entity describing its objectives and strategies, and the actions needed to achieve them 1.2 Integrate the IT systems of the merged entities 1.1 Reallocate personnel and define new roles 0.9 Integrate budgetary processes 0.8 Appoint (confirm) the heads of the new departments of the merged entity 0.7 Source: de Luna, Martínez, and Rose 2003. Note: Countries included in the survey were: Australia, Canada, Denmark, Hungary, Iceland, Korea, Latvia, Luxembourg, Malta, Mexico, Norway, Singapore, Sweden, and the United Kingdom. Dealing with Growing Linkages Across Markets 175 financial system, keeping important powers such between the different goals of regulation. Given the as license authorization and revocation within the diversity of these goals--ranging from preventing domain of the ministry of finance, central bank, or systemic risk to protecting the individual consumer other agencies. from fraud--it is possible that a single regulatory Another important consideration is how far pol- agency might not have a clear focus on the goals and icymakers plan to go in harmonizing regulatory and rationale for regulation and might not be able to dif- supervisory powers across intermediaries. On the ferentiate adequately among different types of insti- one hand, the new integrated agency may want to tutions. Moreover, a poor definition of the goals of have its main departments organized on the basis of the new entity may provide little guidance for the functional regulation, with each department de- regulator when different goals come into conflict. voted to specific functions across all intermediaries. Finally, should a country decide to move to unified On the other hand, the new agency may want to or- supervision, timing is very important. The move to ganize its departments according to the type of fi- unified supervision should preferably be undertaken nancial intermediaries it supervises. when the financial system is stable, allowing man- One of the most difficult tasks of unifying regu- agement more scope to adequately address the many latory agencies is to strike an appropriate balance complex issues associated with organizational change. Statistical A P P E N D I X 1 Tables Diversification allows a financial system to allocate assets more efficiently and bear risks more easily. Since the 1997 financial crisis, policymakers in East Asia have focused on the need to diversify the financial sector, encouraging the participation of different types of specialized intermediaries and markets. Much progress has been made in this respect, but the East Asian economies still lag in the development of their bond markets relative to the other segments of the financial system. 178 East Asian Finance APPENDIX TABLE 1.1 Growth in Real GDP and Components of Aggregate Demand (annual percentage growth rates) Average Hong Kong, Rep. of (without China Indonesia Malaysia Philippines Thailand China Korea Singapore China) Averagea GDP 2004 10.1 5.1 7.1 6.1 6.2 8.6 4.6 8.7 6.6 7.0 2005 9.9 5.6 5.3 5.1 4.5 7.3 4.0 6.4 4.7 5.3 Average 2000­05 9.5 4.8 5.2 4.6 5.0 5.7 5.2 5.0 5.1 5.6 Private consumption 2004 6.4 5.0 10.5 5.8 5.9 7.3 -0.5 8.6 6.1 6.1 2005 7.0 4.0 9.2 4.9 4.4 3.7 3.2 n.a. 4.2 5.1 Average 2000­05 6.6 4.0 7.7 4.5 5.3 3.5 3.8 6.2 5.0 5.2 Investment 2004 14.3 14.1 3.1 4.2 13.8 3.0 1.9 8.4 6.9 7.8 2005 13.6 9.9 9.9 9.9 9.9 9.9 9.9 9.9 9.9 10.3 Average 2000­05 15.1 7.2 5.6 2.1 8.4 2.8 4.4 -0.7 4.3 5.5 Exports 2004 26.7 11.1 16.3 14.1 9.6 15.8 19.7 20.6 15.3 16.6 2005 23.6 8.6 8.4 2.3 4.4 10.7 8.8 11.0 7.7 9.5 Average 2000­05 26.6 5.5 7.2 6.3 7.7 10.5 12.3 n.a. 8.3 10.5 Source: Haver Analytics, national data sources, and World Bank staff estimates. a. Simple average of eight economies. n.a. = not available. APPENDIX TABLE 1.2 Contributions to Growth (annual percentage growth rates) Indonesia Malaysia Philippines Thailand Average Average Average Average 2004 2005 2000­05 2004 2005 2000­05 2004 2005 2000­05 2004 2005 2000­05 Net exports -2.7 -0.5 -0.2 -2.5 1.5 -0.8 2.9 0.0 0.0 -0.6 -2.1 -0.4 Exports 4.3 3.5 2.1 17.7 9.8 7.9 6.2 0.0 2.5 6.2 2.9 4.7 Investment 2.8 2.1 0.9 3.8 -1.6 1.3 1.9 0.0 0.8 3.1 2.9 2.1 Fixed investment 2.8 2.1 1.5 0.9 1.3 1.5 0.9 0.0 0.5 2.9 2.5 1.7 Inventories 0.0 0.0 -0.5 2.9 -2.9 -0.2 1.1 0.0 0.3 0.2 0.2 0.4 Public consumption 0.3 0.6 0.6 0.9 0.9 1.2 0.0 0.0 0.0 0.4 1.0 0.4 Private consumption 3.0 2.4 2.5 4.9 4.5 3.5 4.7 0.0 2.9 3.2 2.4 2.9 GDP growth 3.3 4.6 3.8 7.1 5.3 5.2 9.5 0.0 3.7 6.1 4.2 5.0 Hong Kong, China Rep. of Korea Singapore Average Average Average 2004 2005 2000­05 2004 2005 2000­05 2004 2005 2000­05 Net exports 3.9 5.5 2.5 3.4 1.7 1.4 0.4 0.0 2.1 Exports 25.9 18.7 16.2 8.9 4.6 5.1 0.0 0.0 0.0 Investment 0.5 0.1 1.0 1.4 0.2 1.2 4.8 0.0 -1.0 Fixed investment 0.8 0.9 0.7 0.6 0.6 1.3 2.2 0.0 -0.2 Inventories -0.2 -0.8 0.3 0.8 -0.4 -0.1 2.6 0.0 -0.8 Appendix Public consumption 0.1 -0.3 0.2 0.4 0.5 0.5 -0.2 0.0 0.4 Private consumption 4.1 2.0 2.0 -0.3 1.6 2.0 3.6 1.1 2.3 GDP growth 8.6 7.3 5.7 4.9 4.0 5.1 8.6 1.1 3.9 1: Sta tistical Tables 179 180 East Asian Finance APPENDIX TABLE 1.3 East Asia and Pacific: Investment as Share of GDP (percent) Hong Kong, Rep. of China Indonesia Malaysia Philippines Thailand China Korea Singapore Average 1993­96 41.2 30.8 41.4 23.7 41.0 31.0 37.3 35.1 2000 36.4 22.2 27.3 21.2 22.8 27.5 31.0 32.4 2001 38.0 22.0 23.9 19.0 24.1 25.3 29.3 26.5 2002 39.2 20.9 24.0 17.6 23.8 22.8 29.1 23.7 2003 42.4 17.7 21.6 16.6 24.9 21.9 30.0 15.6 2004 44.2 23.1 22.6 17.0 27.1 21.8 30.4 19.4 2005 n.a. n.a. n.a. n.a. 31.6 20.5 n.a. 18.6 n.a. = not available. APPENDIX TABLE 1.4 East Asia: Foreign Reserves Minus Gold (US$ billions) Hong Kong, Rep. of China Indonesia Malaysia Philippines Thailand China Korea Singapore Dec. 1996 107.039 19.281 27.009 9.905 37.810 63.808 33.201 76.847 Dec. 1997 142.762 17.396 20.788 7.178 26.254 92.804 20.369 71.289 Dec. 1998 149.188 23.516 25.559 9.273 28.825 89.650 51.975 74.928 Dec. 1999 157.728 27.257 30.588 13.282 34.063 96.236 73.987 76.843 Dec. 2000 168.278 29.394 29.523 13.090 32.016 107.542 96.131 80.132 Dec. 2001 215.605 28.016 30.474 13.476 32.363 111.155 102.753 75.375 Dec. 2002 291.128 32.039 34.222 13.329 38.055 111.896 121.343 82.021 Dec. 2003 408.151 36.296 44.607 13.655 41.077 118.360 155.282 95.746 Dec. 2004 614.500 36.320 66.418 13.116 48.665 123.540 198.994 112.232 Dec. 2005 821.514 34.724 70.203 15.927 50.692 124.246 210.317 115.794 Sources: Haver Analytics, Datastream. APPENDIX TABLE 1.5 Net Capital Inflows (US$ billions)a 2002 2003 2004 2005 East Asia 29.2 73.0 152.4 5.6 China 40.1 71.1 137.6 77.9 Southeast Asia -13.9 -12.6 3.2 -12.3 Indonesia -3.8 -3.8 -1.6 -2.5 Malaysia -4.3 -2.9 6.9 -16.8 Philippines -4.5 -1.0 -2.8 1.1 Thailand -1.3 -4.9 0.7 5.7 New industrial economies 3.0 14.5 11.6 -59.8 Hong Kong, China -11.7 -10.0 -10.7 -20.3 Rep. of Korea 13.2 22.0 15.5 -5.3 Singapore -12.3 -13.2 -9.8 -29.6 a. Sum of all capital account flows plus errors and omissions; derived as change in reserves, less current account. Appendix 1: Statistical Tables 181 APPENDIX TABLE 1.6 Net Capital Flows by Type (US$ billions)a Foreign direct investment Portfolio Otherb 2004 2005 2004 2005 2004 2005 East Asia 49.4 77.7 -14.8 -12.1 117.8 -59.8 China 53.0 50.0 19.7 10.0 64.9 17.9 Southeast Asia 2.4 9.7 13.7 13.8 -12.9 -35.8 Indonesia -1.5 2.0 4.4 6.1 -4.5 -10.6 Malaysia 2.6 0.7 8.9 -3.2 -4.6 -14.3 Philippines 0.0 1.1 -1.7 2.1 -1.1 -2.1 Thailand 1.3 3.3 2.1 4.0 -2.7 -1.6 New industrial -6.0 18 -48.2 -35.9 65.8 -41.9 economies Hong Kong, China -11.7 7.7 -39.3 -16.3 40.3 -11.7 Rep. of Korea 4.6 0 8.6 -1.3 2.3 -4.0 Singapore 6.3 14.6 -11.3 -13.7 -4.8 -30.5 Notes: a. Estimates for China, Malaysia, the Philippines, and Hong Kong, China. b. Inclusive of errors and omissions. APPENDIX TABLE 1.7 Financial Sector Profile, 2005 Nominal GDP Bonds Equities Banks US$ US$ % of US$ % of US$ % of Economy billions billions GDP billions GDP billions GDP China 1927.0 552.0 28.6 401.9 20.9 3,692.2 191.6 Hong Kong, China 178.2 82.9 46.5 1,055.0 591.9 790.1 443.3 Indonesia 204.7 55.2 27.0 81.4 39.8 140.0 68.4 Rep. of Korea 801.1 599.8 74.9 718.0 89.6 736.1 91.9 Malaysia 128.4 115.1 89.7 180.5 140.6 208.5 162.5 Philippines 101.4 36.1 35.6 39.8 39.3 62.2 61.3 Singapore 116.8 79.6 68.2 257.3 220.3 216.4 185.3 Thailand 179.3 72.1 40.2 123.9 69.1 183.0 102.1 TOTAL 3,636.8 1,592.8 43.8 2,857.8 78.6 5,238.4 144.0 Germany 3,093.3 1,977.8 63.9 1,221.1 39.5 5,847.9 189.0 Japan 4,929.5 8,763.7 177.8 4,572.9 92.8 7,076.4 143.6 United Kingdom 2,337.8 1,014.1 43.4 3,058.2 130.8 7,614.5 325.7 United States 12,479.5 19,186.6 153.7 17,000.9 136.2 9,743.7 78.1 Sources: GDP: World Development Indicators, IMF International Financial Statistics (June 2005). Bonds: World Federation of Exchanges Annual Report and Statistics, 2005; BIS tables 16A, 16B; ADB, Asian Bonds Online. Equities: World Federation of Exchanges, Annual Report and Statistics, 2005, Table 1.1. Banks: IMF International Financial Statistics (June 2005). 182 East Asian Finance APPENDIX TABLE 2.1 Intra-Region Cross-Border Banking Investments Year of announcement Investor Investee/target Transaction details 2001 DSB Group, holding Dao Heng Bank DBS Group bought 71% of company of DBS bank (Hong Kong, China) Dao Heng Bank from (Singapore) Hong Kong­based Guoco Group HSBC (Hong Kong, China) Bank of Shanghai (China) HSBC acquired a % holding in Bank of Shanghai 2002 Hang Seng Bank HSBC Industrial Bank Co Ltd Hang Seng acquired 15.98% subsidiary (Hong Kong, (China) and IFC acquired a China) and IFC 4% equity stake 2003 Consortium led by Tamasek Bank Danamon (Indonesia) Majority stake (Singapore) and Deutsche Bank (Germany) Kookmin Bank (Korea) Bank International 51% stake and Tamasek Holdings Indonesia (Indonesia) (Singapore) 2004 DBS Group (Singapore) Thai Military Bank and 16% stake Industrial Finance (Thailand) OCBC (Singapore) Bank NISP (Indonesia) 22.5% stake HSBC (Hong Kong, China) Bank of Communications 19.9% stake (China) Wang Hang Bank First Sino Bank 5% stake (Hong Kong, China) (Shanghai-based, China) 2005 Tamasek (Singapore) Langkah Bahagia (Malaysia). 15.4% stake Under the deal, Langkah Bahagia has sold a 15.4% stake in Malaysian Plantations, the 100% shareholder of Alliance Bank Berhad. Tamasek (Singapore) China Construction Bank 5.1% stake (China) from SAFE Investments Ltd. Appendix 1: Statistical Tables 183 APPENDIX TABLE 4.1 Indicators of Health of the Banking Sector (percent) 1997 1998 1999 2000 2001 2002 2003 2004 2005 Nonperforming loan ratio Indonesia 7.2 48.6 32.9 18.8 12.1 7.5 6.8 6.2 7.6 Rep. of Korea 6.0 7.3 13.6 8.7 3.3 2.4 2.7 2.0 1.3 Malaysia - 16.7 16.7 13.4 16.3 14.7 13.1 12.3 10.1 Philippines 4.7 10.4 12.3 15.1 17.3 15.0 14.1 12.7 8.5 Thailand 45.0 39.9 19.5 11.5 18.1 13.9 11.6 8.3 Singapore Hong Kong, China Interest margins Indonesia 1.8 -6.9 6.0 3.1 3.5 6.4 7.7 Rep. of Korea Malaysia 1.3 3.5 3.3 3.2 3.4 3.0 3.0 Philippines 5.9 5.7 3.7 3.5 3.4 3.5 3.5 Thailand 2.7 -0.3 1.1 1.6 1.8 2.0 2.4 Singapore 2.8 2.9 4.1 4.2 4.5 4.8 4.9 Hong Kong, China 3.5 2.4 4.7 2.85 4.7 4.9 5.0 Rate of return on assets Indonesiaa 1.4 -18.8 -6.1 1.6 1.5 2.0 2.6 3.5 2.6 Rep. of Korea -1.0 -3.0 -1.3 -0.5 0.8 0.6 0.6 0.9 0.9 Malaysiab 1.3 1.1 1.4 0.9 1.2 1.2 1.4 1.4 Philippinesc 1.8 0.8 0.7 0.4 0.5 0.8 1.2 0.9 1.2 Thailand -1.4 -6.1 -7.1 -0.2 1.5 0.2 0.7 1.2 1.4 Singapored 0.4 1.3 0.8 0.8 0.9 1.4 Hong Kong, Chinae 1.6 1.0 1.3 1.2 1.4 1.4 1.5 Capital-adequacy ratio Indonesia 9.1 -15.7 -8.1 2.1 18.9 22.4 19.4 19.4 19.3 Rep. of Korea 6.6 8.2 10.9 10.5 10.8 10.2 10.4 11.3 13.0 Malaysia 10.3 11.7 12.5 12.2 12.8 13.2 14.0 14.3 13.1 Philippines 15.9 17.5 17.0 15.6 15.3 16.6 17.3 17.1 18.4 Thailand 8.6 10.2 13.6 11.3 13.3 13.0 13.4 11.9 13.3 Singapore 18.3 19.6 18.1 16.9 17.9 15.5 Hong Kong, China 17.4 18.5 17.8 16.5 15.7 15.3 15.4 a. Commercial banks, Bank of Indonesia Annual Report, Financial Stability Review. b. Commercial banks, Bank Negara Malaysia Annual Report. c. Universal and commercial banks, BSP selected indicators of financial sector. d. IMF Global Financial Stability report, various issues. e. Hong Kong Monetary Authority consolidated all authorized institutions. 184 East Asian Finance APPENDIX TABLE 4.2 Regulations for Foreign Bank Entry Minimum capital Limitations on Limitations on Economy Selection criteria requirements branches foreign ownership Indonesia Must be among top 200 Higher paid-up capital Branch offices allowed Liberalized in 1999 to banks worldwide and required for foreign only in 10 cities. maximum of 99% have minimum A rating banks. foreign ownership. by credit-rating agency. (But still need approval Screened from Bank of Indonesia for any acquisition of over 25%.) Rep. of Must be among the top No restrictions on No restrictions, except Korea 150 banks worldwide branches or represen- restrictions on single to top 5 in country of tative offices. Foreign ownership (including origin. branches allowed groups), which applies Screened. since 1967. Branches generally. For domestic may only be opened shareholders it is 4%. one year after the For foreign sharehold- establishment of a ings the limit is 10 % representative office. and greater flexibility is allowed for foreign investors in joint ventures. Malaysia Screened. Since 1971 no new Foreign ownership of foreign banks allowed existing bank limited to enter, and those to 30%. remaining are prohib- Single ownership limits ited from expanding of 10%. their branches and establishing offsite ATMs. Philippines Screened. 10 new branches allowed Foreign shareholding or between 1995 and acquisition in new 2000, with a limit of 6 investment limited to from a single bank. 51%. The foreign share of total banking assets is limited to maximum of 30%. Single owner- ship limit of 40%. Thailand Screened. Last foreign bank branch Since 1997, foreign share- to be licensed was in holdings in commercial 1978. Foreign banks banks up to 100% limited to one branch for 10 years. After office. 10 years, foreigners not permitted to acquire additional shares unless their holdings are less than 49%. Limitation on individual ownership to 5%. Appendix 1: Statistical Tables 185 APPENDIX TABLE 4.3 Number of Mergers and Acquisitions Involving Commercial Banks in East Asia, 2000­04 Mergers Private-led involving Government-led Private-led foreign banks Privatization Indonesia 2000 1 (11) 1(2) 2001 1(2) 2002 1(5) 2003 1(2) 2004 1(3) Rep. of Korea 2000 1(2) 2001 1(5) 2(3) 2002 1(2) 1(1) 2003 1(2) 2(2) 2004 Malaysia 2000 3(6) 2001 7(14) 2002 1(2) 2003 5(10) 2004 Philippines 2000 7(16) 2001 3(6) 2002 4(8) 1(2) 2003 2004 Thailand 2000 2001 2002 1(2) 2003 1(2) 2004 Hong Kong, China 2000 2(4) 2001 1(10) 2002 2(4) 2003 3(8) 1(3) 2004 Singapore 2000 1(2) 2001 2002 3(5) 2003 2004 Sources: Central bank annual reports, Bankscope, Bankers' Almanac. Note: Numbers of banks involved in the merger are in parentheses. 186 East Asian Finance APPENDIX TABLE 6.1 Summary of Minimum Capital Requirements for Entry into Insurance Markets US$ equivalent of Economy Description lowest figure China RMB 200 mn plus capital per branch RMB 20 mn subject to a maximum RMB 500 mn. RMB 200 million = On establishment, 20% of a company's registered capital must be deposited with a bank US$24.9 million designated by the CIRC as a guarantee fund. The deposit is increased in line with capital increases. Hong Kong, - HKD 10mn for a life insurer or a non-life insurer not writing compulsory classes. HKD 10 million = China - HKD 20mn for a non-life insurer writing compulsory classes. US$1.3 million - HKD 20mn for a composite. New applicants submit a business plan. The applicant and the authorities agree how much capital they will need based on the business plan, normally higher than the statutory minimum. Foreign branches do not have to make a capital deposit, and only non-life companies are sub- ject to an asset localization rule, that they are required to maintain assets in Hong Kong, China at 80% of net liabilities and solvency margin with respect to the domestic business. Indonesia The minimum paid-up capital requirements prior to 1999 were: IDR 2 billion = - Indonesian-owned companies: IDR 2 billion. US$0.2 million - joint venture companies: IDR 4.5 billion. This was harmonized in 1999 for all new companies to IDR 100 bn for direct-writing companies regardless of the nationality of the shareholders. Existing companies were exempt from the change provided they met new risk-based capital provisions. A collateral deposit is required with an approved bank or banks in the name of the Ministry of Finance for 20% of the paid-up capital. Rep. of Minimum capital levels are calculated by class of business. The minimum capital for a KRW 5 billion = Korea mono-line insurer writing only engineering or title insurance is KRW 5 bn. The lowest US$5.1 million limit for a life insurer is KRW 10 billion. For a multi-line life or non-life insurer, the sum of the various requirements applies subject to a maximum of KRW 30 bn. If the company obtains at least 90% of its business through direct channels (phone, mail, Internet) then the figure is reduced by one third. Malaysia Minimum paid-up capital is MYR 100 mn. Licensed foreign insurers other than a licensed MYR 100 million = foreign professional reinsurer must also maintain, in Malaysia, a surplus of assets over US$26.9 million liabilities of an amount not less than the required minimum paid-up share capital. Philippines For new companies (life and non-life) and existing life companies: PHP 30 million = - A domestic insurer: PHP 75 mn plus a surplus fund of PHP 25 mn. US$0.6 million - A foreign-owned insurer: - PHP 250 mn plus a surplus fund of PHP 50 mn, where foreign equity is 60% or more. - PHP 150 mn plus a surplus fund of PHP 50 mn where foreign equity is between 40% and 60%. - PHP 75 mn plus a surplus fund of PHP 25 mn where foreign equity is 40% or less. Branch offices of foreign companies must deposit securities with the authorities of not less than PHP 300mn. For existing non-life companies: - non-life domestic companies with paid-up capital less than PHP 30 mn can write up to three times their paid-up capital. - those with paid-up capital of PHP 50 mn or more have no limit. Singapore For a non-life insurance company, minimum capital is: SGD 5 million = - for a mono-line insurance company (one class of business only): SGD 5 million. US$3.1 million - for a direct insurer (multi-class): SGD 10 million. For a life insurer, the minimum is SGD 5 million. Composite insurers have a minimum of SGD 10 million. Thailand For non-life insurers the minimum capital requirement is THB 30 million, but companies THB 30 million = licensed from 1997 are required to have THB 300 million. US$0.8 million For life insurers, companies licensed since 1995 must have minimum capital of THB 500 million. Companies established before this date have a requirement that is 2% of reserves, subject to a minimum of THB 50 million. Non-life insurers must also lodge a security deposit with the authorities of THB 3.5 mil- lion for each class of business written. For this purpose, non-life business is divided into four classes: fire, marine and transit, motor, and miscellaneous. Life insurers must place a security deposit of THB 20 million. Appendix 1: Statistical Tables 187 APPENDIX TABLE 6.2 Summary of Provisioning and Capital Regulations in Insurance Markets Economy Solvency margin Regulation of technical provisions China Non-life leverage rule: Net retained premiums may not Non-life insurers are required to establish unearned exceed four times a company's capital and surplus. premium reserves, catastrophe reserves, and Solvency margin: defined as the difference between a claims reserves including IBNR. Reserves may be company's admissible assets and its liabilities: established net of ceded reinsurance. New regulations came into effect on December Non-life: the greater of: 15, 2004 and introduced international stan- - 18% of net premium up to RMB 100 million plus 16% of dards of reserving practice particularly the the excess, or proportionate methods for UPP. - 26% of the average of the last three years' net incurred claims up to RMB 70 mn plus 23% of the excess. Outstanding-loss reserves must represent the full settlement cost, are established on a gross Insurance companies that have been in business for less basis, and may not be discounted for the time than three years are only required to meet the pre- value of money. IBNR reserves are calculated mium income solvency measure. by two recognized methods; the higher result is adopted. Life: The sum of: - 4% of the year-end mathematical reserve for traditional Life insurers establish a mathematical reserve business; using tables that are either equivalent to or - 1% of the year-end mathematical reserve for unit-linked more conservative than the approved pricing- business; mortality tables. The interest rate is prescribed - 0.1% of total sums assured for term-life policies with as the lower of 7.5% and the assumed pricing terms of less than three years; rate. The maximum permissible interest rate for - .15% of total sums assured for term-life policies with terms pricing current new business is 2.5%. Allowance of more than three years but less than five years; and for initial expenses in the valuation is permitted - 0.3% of total sums assured for term-life policies with through the Zillmer method. terms in excess of five years. Hong Kong, Minimum: For non-life insurers the minimum solvency For life insurance, regulations specify, among China margin (admissible assets over liabilities) is set at the other things, the rate of interest to be applied minimum capital requirement of HKD 10 mn or for long-term business. HKD 20 mn respectively depending on whether or not For non-life insurance there are no statutory the company writes compulsory classes. For life insurers, reserve requirements, though the authorities the minimum is HKD 2 mn. The minimum solvency expect companies to comply with prudential margin for composite insurers is the applicable non-life guidance notes providing for unearned pre- figure plus HKD 2 mn in respect of long-term business. mium reserves, unexpired risk reserves, claims For non-life insurers, the required solvency margin is reserves, and IBNR reserves. There is no determined on a premium income or a claims requirement for equalization reserves or catas- outstanding basis, whichever is the greater. The margin trophe reserves. Non-life provisions are not is then 20% of premiums or claims up to HKD 200 mn normally discounted as this requires permission and 10% of the excess. "Premiums" are defined as the from the authorities and such permission is not greater of 50% of gross written premiums or 100% normally given. of gross written premiums less ceded reinsurance. Annual actuarial review of claims reserves is Outstanding claims are defined as the greater of 50% required for all non-life insurers with gross writ- of gross claims outstanding or 100% of gross claims ten premiums or technical reserves for vehicle outstanding less reinsurance recoveries plus the third-party liability and worker's compensation unexpired risk reserve. over HKD 20 mn. For life insurers, the solvency margin is the sum of: For all types of insurance, credit for reinsurance is - a percentage of the mathematical reserve (generally allowed provided that the authorities are satis- 4% for traditional business and 1% for unit-linked fied as to recoverability. Guidance has been business); and issued tying this satisfaction to rating-agency - a percentage of the sum at risk (0.3% for traditional grades and, for those of lower grade, collateral. business). Reinsurance with related companies is subject to a special limitation. Indonesia All companies are required to maintain a ratio of assets to Regulations introduced in 1999 and 2003 require liabilities of at least 120% of risk-based capital (RBC). unearned premium reserves at specified and RBC was phased in as follows: conventional rates, provisions to be made for 2000: 15% outstanding claims on the basis of "reasonable 2001: 40% estimates," and IBNR reserves. Life insurers are 2002: 75% also obliged to determine reserves consistent 2003: 100% with the above and to use a net premium 2005: 120%. method for their traditional business subject (continued) 188 East Asian Finance APPENDIX TABLE 6.2 Summary of Provisioning and Capital Regulations in Insurance Markets (continued) Economy Solvency margin Regulation of technical provisions Indonesia The RBC formula is based on a series of risk measures to a maximum rate of interest assumed (9% for (Cont'd) including asset-default risk, cash-flow mismatch, risk of IDR-denominated policies and 5% for foreign- deterioration in anticipated claims, reinsurance risks, denominated policies). and the risk of insufficient premium due to worse than For non-life insurers, 1% of net premium is required anticipated investment results. to be held as part of the collateral deposit Companies that fail to meet the phase-in requirements arrangements. For life insurers, the equivalent should have a rectification plan with the insurance allocation is 5% of the premium reserve directorate. It is generally considered that not all including reserve for unearned premiums. companies met the phase-in plan on the due dates. Rep. of Short-term insurance: the greater of For short-term business, companies are required Korea - 17.8% of the previous year's net retained premiums, or to maintain unearned-premium reserves, - 25.2% of the average of the previous three years' catastrophe reserves, and claims reserves. net incurred claims. Long-term insurance: 4% of the reserves for the savings Unearned-premium reserves are calculated in dif- element plus the short-term insurance requirements ferent ways for different classes of business and with respect to the risk elements of the business. may be established net of ceded reinsurance. Admissible assets for solvency purposes comprise the usual Catastrophe reserves may be accumulated in capital items, subordinated debts plus several reserve proportion to underwriting profit until they items such as catastrophe reserves, asset-soundness reach a maximum of 50% of the previous provisions, excess reserves for savings premiums. year's net earned premium. The corporate tax Inadmissible assets are deferred acquisition costs, law effectively limits annual increases in intangibles, pre-paid expenses, and deferred tax liabilities. catastrophe reserves to 2% of net earned premiums excluding savings premiums. Subordinated debt may not exceed 50% of shareholders' Claims reserves must represent the full cost of equity. settling incurred claims without discounting A risk-based capital system is to be implemented in 2007. and may be established net of anticipated reinsurance recoveries. IBNR reserves are required for short-term business lines and were introduced in 2004 for long tail lines as well as with a three-year transition period. Other long-term business is subject to a net pre- mium valuation approach under the regulation but with scope for acceptable or necessary alternatives mandated by the FSS. Malaysia For non-life insurance: the higher of the following: For non-life insurers, regulations require provisions - 25% of the first MYR 50 mn of net premium and 20% of to cover insurers' potential liabilities. Unearned the excess or premium provisions for all non-life classes - 26% of the first MYR 25 mn of net incurred claims and other than marine need to be calculated on the 23% of the excess 1/24ths system, at least, with a provision of - MYR 50 mn. 20% for general expenses and acquisition costs. For life insurance: In the case of marine cargo, aviation, and transit, Several specified percentages of mathematical provisions, not less than 25% of the annual premiums must sums at risk, and net premiums are applied subject be reserved. Although claims and IBNR to a minimum of MYR 50 mn for direct insurers and provisions are required, their determination MYR 10 mn for branch operations. is less specific. IBNR provisions must be Companies transacting life and non-life insurance business determined on the insurer's claims statistics maintain separate solvency margins for each class. for the previous seven years. Actuarial certification of the outstanding claim provisions is not compulsory but can be required by the authorities. For life insurance, net premium valuation methods with defined discount rates and mortality tables are prescribed. Philippines For non-life companies, 10% of the net premium income. Non-life insurers must maintain a provision of For life insurance companies, 2% per thousand of the total 40% of gross premiums for all classes except amount of insurance in force. marine cargo, where a separate but Both are subject to a minimum margin, of PHP 500,000. equivalently intended formula applies. For life insurance, a net-premium valuation method with prescribed mortality tables and maximum discount rates applies. (continued) Appendix 1: Statistical Tables 189 APPENDIX TABLE 6.2 Summary of Provisioning and Capital Regulations in Insurance Markets (continued) Economy Solvency margin Regulation of technical provisions Singapore For both life and non-life insurers, a risk-based capital Non-life insurers must follow generally accepted margin is determined, introduced in 2004. The formula is accounting principles, bases, and policies, follow subject to a minimum of SGD 5 mn and the authorities actuarial principles, make proper provisions for intervene at a trigger of 120% of the minimum. all liabilities, and use prudent assumptions. The requirements take into account insurance risks and Non-life insurers are required to hold provisions investment risks. The authorities can adjust capital for unearned premiums at least at the level of requirements to capture risks that cannot be quantita- accuracy of the 1/24ths method, or an unexpired tively determined, such as operational risks. risk provision if higher, reflecting a 75% level of sufficiency. Provisions for outstanding claims are also prescribed at the same level of sufficiency. Actuarial certification of premiums and claims reserves based on 75% level of sufficiency was introduced in 2002. Detailed rules also exist to oversee life-insurance provisioning. Thailand The non-life solvency margin required is 10% of the Under the Non-Life Insurance Act, 1992, companies preceding year's written premium net of reinsurance, are required to establish premium and claim subject to a minimum of THB 30 mn. reserves. Unearned premium reserves should use The life insurance solvency margin is 2% of reserves the 1/24ths method although the more accurate subject to the THB 50 million minimum. 365ths basis is also used. Claims reserves should be determined on a prudent and conservative incurred basis without discounting. A minimum IBNR provision of 2.5% of net written premiums is required. An equalization reserve is required setting aside at least 5% of net income each year until it reaches 10% of capital. Life insurers are subject to specific reserve require- ments related to the surrender value, the net premium reserve, and the annual net premium. International A P P E N D I X 2 Financial Reporting Reliable and comprehensive information on financial institutions' financial condition is fundamental to effective corporate gover- nance, market discipline, and official oversight. If such informa- tion is not available, market discipline may not be properly imposed and, consequently, the safety and soundness of the finan- cial system may not be assured. In this context, the adoption of Diversification allows a internationally accepted accounting standards would facilitate the financial system to allocate production of transparent financial statements and high-quality data on financial institutions as well as the financial sector at large. assets more efficiently and The International Financial Reporting Standards (IFRSs) have bear risks more easily. Since been developed by the International Accounting Standards Board the 1997 financial crisis, (IASB) to secure international consistency and harmony in accounting standards.160 They are comprehensive and well- policymakers in East Asia defined accounting principles that command wide international have focused on the need acceptance. Many countries have either adopted the IFRSs or are to diversify the financial basing their local standards on them. The framework of the IFRSs defines the objectives of financial sector, encouraging the statements, identifies the qualitative characteristics that make participation of different information useful, and defines the basic elements of financial statements and the concepts in recognizing and measuring them. types of specialized The IFRSs address the general-purpose financial statements intermediaries and designed to meet the needs of shareholders, creditors, employ- markets. Much progress ees, government agencies, and the public for information about a public entity's financial position, performance, and cash flows. has been made in this They are not tailored to meet the specific information needs of respect, but the East Asian users. However, it should be emphasized that all the standards are applicable to financial institutions as well as to commercial economies still lag in the enterprises. Moreover, some of the standards are particularly development of their bond important in the financial sector and have a significant effect on markets relative to the financial institutions. Below is a summary of the standards that are particularly important for well-functioning financial markets. other segments of the financial system. IAS 1: Presentation of Financial Statements IAS 1 sets forth the broad guidelines for the presentation and preparation of financial statements and the basis for comparabil- ity both with the entity's financial statements of previous periods and with the financial statements of other entities. The objective of general-purpose financial statements is to provide information 191 192 East Asian Finance about assets, liabilities, equity, income, and expenses principles, bases, conventions, rules, and practices including gains and losses, other changes in equity, applied by an entity in preparing and presenting and cash flows. Therefore, a complete set of finan- financial statements. cial statements should include a balance sheet, A change in accounting estimates is an adjust- income statement, changes in equity statement, cash ment of the carrying amount of an asset or liabil- flow statement, and accounting policies and notes. ity, or related expense, resulting from reassessing the The standard requires a fair presentation of the expected future benefits and obligations associated financial position, financial performance, and cash with that asset or liability. Prior-period errors are flows of an entity--that is, the faithful representa- omissions from, and misstatements in, an entity's tion of the effects of transactions, other events, and financial statements for one or more prior periods conditions in accordance with the definitions and arising from a failure to use, or from misuse of, reli- recognition criteria for assets, liabilities, income, able information that was available and could rea- and expenses. The standard also covers going con- sonably be expected to have been obtained and cern, accrual basis, consistency, materiality and taken into account in preparing those statements. aggregation, offsetting, comparative information, Changes in accounting policy and correction of reporting period, balance sheet, income statement, errors should be accounted for retrospectively, with changes in equity statement, accounting policies comparative information restated along with the and notes, and disclosures about dividends. amount of the adjustment. Changes in accounting estimates are accounted for in the income statement IAS 7: Cash-flow Statements when identified. The standard also requires disclo- sure relating to changes in accounting policies and IAS 7 requires the presentation of information about estimates, and prior-period errors presenting major the historical changes (inflows and outflows) in cash items to be disclosed. and cash equivalents of an entity by means of a cash- flow statement, which classifies cash flows during the period according to operating, investing, and finan- IAS 14: Segment Reporting cial activities. This statement should help users to IAS 14 establishes principles for reporting financial assess an entity's ability to generate positive future information about different components of an cash flows and meet its obligations and pay divi- entity's operations, as well as by line of business and dends, the reasons for differences between income by geographical area, based on a profile of risks and and associated cash receipts and payments, etc. returns and internal reporting structure to help Operating activities are the main revenue- financial statement users better understand the producing activities of the entity aside from invest- entity's performance. This must be applied by enti- ment or financing activities, so operating cash flows include cash received from customers and cash paid ties whose debt or equity securities are publicly to customers and employees. Investing activities are traded and those in the process of issuing such secu- the acquisition and disposal of long-term assets and rities in public securities markets. other investments that are not considered cash The purpose of segment reporting is to assist equivalents. Financing activities are activities that investors and lenders in assessing risks and returns alter the equity capital and borrowing structure of and the potential of an entity, and in making more the entity. informed judgments. The standard defines report- able segments as business and geographical seg- ments for which a majority of revenue is earned IAS 8: Accounting Policies, Changes in from business activities, one as primary format, the Accounting Estimates, and Errors other as secondary. Major criteria are 10 percent or IAS 8 sets forth the guidelines for selection and more of total revenue, 10 percent or more of total application of accounting policies, consistency of profit or loss, and 10 percent or more of total assets. accounting policies, changes in accounting policies IAS 14 details guidance as to which items of revenue and accounting estimates, and corrections of prior- and expense are included in segment revenue and period errors. Accounting policies are the specific expense. Appendix 2: International Financial Reporting 193 IAS 21: The Effects of Changes IAS 27: Consolidated and Separate in Foreign Exchange Rates Financial Statements IAS 21 prescribes how to include foreign-currency IAS 27 requires the preparation by a parent entity of transactions and foreign operations in the financial consolidated financial statements that cover all statements using a presentation currency. The stan- subsidiaries. The objective of the standard is to dard covers reporting of foreign-currency trans- provide users of the financial statements with infor- actions, conversion of the results and financial mation about the financial position, results of opera- positions of foreign operations, and treatment of tions, and changes in financial position of the group the disposal of foreign operations. The objectives as a whole. It includes sets of standards to be applied of the conversions are to provide information rela- in the preparation of consolidated financial state- tive to the expected economic effects of exchange- ments for a group of entities under the control of a rate changes on an entity's cash flows and equity, parent, and in the accounting treatment of invest- and financial results of each individual foreign con- ments in subsidiaries, jointly controlled entities, and solidated entity as reflected by the functional cur- associates when an entity elects, or is required by local rency of the reporting entity. regulations, to present separate financial statements. The principal issues concern which exchange The standard covers identification of sub- rate(s) to use for recording and conversion pur- sidiaries, presentation of consolidated accounts, and poses, and how to report the effects of changes in consolidation procedures. It also sets guidelines on exchange rates in the financial statements. Basically, the disclosure required in both consolidated finan- the conversion of transactions denominated in for- cial statements and separate financial statements eign currency is at the exchange rate in operation on that are prepared for a parent that is permitted not the date of the transaction, followed by reporting to prepare consolidated financial statements. using the closing or historical rates at each subse- quent balance-sheet date, whereas the amounts in IAS 30: Disclosures in Financial the foreign operation's balance sheet are translated Statements of Banks and Similar using the closing rate. The exception is equity bal- Financial Institutions ances, for which the historical exchange rate is used. IAS 30 prescribes appropriate presentation and dis- closure standards for banks and similar financial IAS 24: Related-party Disclosures institutions that supplement the requirements of IAS 24 requires that an entity's financial statements other standards. It encourages the management of a contain the disclosures necessary to draw attention bank to provide a commentary on the financial to the possibility that its financial position and statements that describes the way it manages and profit or loss may have been affected by the exis- controls its liquidity and solvency, as well as the full tence of related parties and by transactions and out- spectrum of risks associated with the operations of standing balances with such parties. Related-party the bank. The goal is to provide users with infor- relationships are generally determined by reference mation required to evaluate the financial position to the control or indirect control of one party by and performance of banks and to enable them to another, or by the existence of joint control or sig- better understand the special characteristics of nificant influence by one party over another. banking operations. The objective of the standard is to define related- The standard requires a bank to present a bal- party relationships and transactions and to enhance ance sheet that groups assets and liabilities by disclosure thereof. A related-party transaction is a nature and lists them in an order that reflects their transfer of resources, services, or obligations between relative liquidity, as well as prescribes specific assets related parties. If there are transactions between and liabilities to be disclosed. It also prescribes spe- related parties, the entity must disclose the nature of cific items of the income statement to be reported. the related-party relationship as well as information Additional disclosure requirements include fair val- about the transactions and outstanding balances nec- ues of financial assets and liabilities, off-balance essary for understanding the potential effect of the sheet items, maturities and concentrations of assets relationship on the financial statements. and liabilities, losses on loans and advances, 194 East Asian Finance amounts set aside for general banking risks, and carrying amount. The standard requires disclosures assets pledged as security. by both class of assets and segment. Also, individ- ual impairment loss and/or aggregate impairment loss should be disclosed in accordance with the IAS 32: Financial Instruments: materiality consideration. Disclosure and Presentation The objective of IAS 32 is to enhance financial- IAS 39: Financial Instruments: statement users' understanding of the significance Recognition and Measurement of on- and off-balance-sheet financial instruments to an entity's financial position, performance, and The objective of IAS 39 is to establish principles for cash flows, and the assessment of the amounts, tim- recognizing, measuring, and disclosing information ing, and certainty of future cash flows associated about financial instruments in the financial state- with those instruments. The standard prescribes ments. The standard requires that all financial assets requirements for the presentation of on-balance- and liabilities, including all derivatives, be recog- sheet financial instruments and identifies infor- nized on the balance sheet. Financial assets and mation that should be disclosed about both liabilities should be recognized when the entity on-balance-sheet and off-balance-sheet financial becomes a party to the contractual provisions of the instruments. financial instrument. The initial measurement of the The standard requires that a financial instrument financial assets is their fair value, which is normally be classified as either a financial liability or an equity the consideration given, including directly related instrument according to the substance of the con- transaction costs. Subsequently, those should be tract, not its legal form. In the case of compound measured at fair value with some exceptions. instruments, which have both a liability and an The standard requires financial assets to be classi- equity component from the issuer's perspective, it fied in one of four major categories to determine how requires that component parts be accounted for and a particular financial asset is recognized and mea- presented separately according to their substance. sured in the financial statements: financial assets at The standard also covers disclosure requirements fair value through profit or loss, available-for-sale for all financial instruments; it requires disclosures financial assets, loans and receivables, and held-to- about risk management, terms and conditions of maturity investments. The general principle is that financial instruments, interest rate and credit risks, available-for-sale financial assets are measured at fair fair value of financial instruments, and hedging. value in the balance sheet, whereas held-to-maturity investments are measured at amortized cost. In addition, IAS 39 recognizes two classes of IAS 36: Impairment of Assets financial liabilities: financial liabilities at fair value IAS 36 requires that assets be carried at no more through profit and loss, and other financial liabili- than their recoverable amount and defines how the ties at amortized cost using the effective-interest recoverable amount is calculated. It requires an method. Initial measurement is at fair value, which entity to consider impairment when there is an is usually the consideration received minus trans- indicator of impairment, and to disclose it. IAS 36 action costs. has a list of external and internal indicators of IAS 39 significantly increases the use of fair value impairment with materiality consideration. The in accounting for financial instruments, particularly objective of the standard is to provide detailed guid- on the asset side of the balance sheet. Accordingly, ance on how to exercise prudence in measuring the reporting most liabilities at cost, while introducing amounts of assets shown on the balance sheet. more fair-value accounting on assets, is likely to The standard applies to most assets including increase the risk of volatility in earnings and equity. land, buildings, machinery and equipment, invest- IAS 39 permits hedge accounting under certain ment property carried at cost, intangible assets, circumstances that meet stringent qualifying crite- goodwill, investments in subsidiaries, associates, ria in relation to documentation and hedge effec- and ventures. An impairment loss should be recog- tiveness. The standard uses specific criteria as a nized whenever the recoverable amount is below the precondition for hedge accounting. Basel II A P P E N D I X 3 Issues The Basel II Accord was designed to address weaknesses of the 1988 Basel Capital Accord (Basel I) and to help disseminate best practice in risk management within an integrated framework for banks, supervisors, and other stakeholders. Although Basel I had proved effective until the mid-1990s in raising capital levels and in leveling the playing field for the G-10 countries' internationally Diversification allows a active banks, the dramatic changes that then took place in the way financial system to allocate these banks carry out their activities progressively reduced the efficacy of Basel I. The same trends in banking are being witnessed assets more efficiently and in East Asia and may be expected to gather strength over time. bear risks more easily. Since Most of Basel I's current weaknesses originate in its crude the 1997 financial crisis, measurement of risks. For instance, there is mainly one risk weight161 for corporate exposures (100 percent), which has gen- policymakers in East Asia erated some perverse incentives, including for banks to: have focused on the need Sell high-quality assets and retain exposures to lower-quality to diversify the financial borrowers, since both are subject to the same charge, irrespec- sector, encouraging the tive of the underlying differences in risk profiles. Arbitrage regulatory ratios through securitization. By securi- participation of different tizing assets while providing credit enhancements to the secu- types of specialized ritization, for example by keeping its subordinate tranche, banks may continue to hold the bulk of the credit risks even intermediaries and though these are not reflected in their Basel I ratios. markets. Much progress Increase their operations without much impact on their capi- has been made in this tal ratios. For instance, Korean banks in the past were able to increase the credit-card business or to offer very large credit respect, but the East Asian lines to corporations while maintaining their capital ratios economies still lag in the broadly unchanged, since commitments with a maturity of less than one year have a zero percent risk weight. development of their bond markets relative to the A large proportion of the advanced industrial countries' inter- nationally active banks in recent years have significantly altered other segments of the their strategy, from holding assets on their balance sheets to financial system. actively managing and redistributing risks. This trend has consid- erably heightened the weaknesses associated with Basel I. Indeed, in recent years the correlation between banks' risk portfolios and capital ratios has decreased, while the probability that banks with similar capital ratios face different levels of risk has increased. Moreover, Basel I does not provide clear incentives for banks to improve their risk management. 195 196 East Asian Finance Basel II is intended to accommodate the changes The scope of application (some countries will in the most sophisticated banks' risk profiles and to implement Basel II only for their largest banks provide incentives for all banks to improve their while others will apply it to all their credit risk-management processes. Consequently it in- institutions).163 cludes both advanced approaches, developed to The implementation time frame (for example, measure the most sophisticated institutions' risks Malaysian banks should be authorized to apply using a "common language," and standardized the Standardized Approach (SA) in 2008 and the approaches which (though simpler than the ad- Foundation Internal-Ratings-Based Approach vanced approaches) are more risk-sensitive than (F-IRB) in 2010).164 Basel I and should encourage banks to progressively The set of approaches that will be implemented catch up with the most sophisticated institutions.162 domestically. While all three pillars are seen to be Some banking systems in the region, such as those mutually reinforcing for the success of the new of Singapore and Hong Kong (China), clearly regulatory framework, countries could consider encompass the entire range of institutions for which adopting Pillars 2 and 3 even if the implementa- Basel II was designed. tion of the Pillar 1 advanced approaches is not Much attention has been devoted to the techni- deemed appropriate. Indeed, Pillars 2 and 3 cal aspects of the so-called Pillar 1 advanced ap- largely embody good banking and good bank- proaches. However, while good progress has been ing supervision principles that should be part of made in quantifying risk in recent years, risk man- all supervisory systems. Conversely, devoting agement is also a matter of expert knowledge and insufficient resources and efforts to implement- judgment. An important benefit of Basel II should ing Pillars 2 and 3 is likely to result in failure to come from the greater awareness of risk that is achieve the objectives of better risk management instilled in banks, incentives for improved risk and financial stability envisaged under Basel II. analysis and management systems, and the greater incentives for correctly allocating capital and pric- Some countries may decide not to apply some ing risks. The increased role that Basel II gives to approaches (e.g. the operational risk Ad- risk officers, as well as the greater risk awareness of vanced Measurement Approach (AMA) in lending officers that it should stimulate, are impor- Hong Kong (China) or the F-IRB in the tant aspects of the framework. The improved risk United States). awareness of the institutions and a more formal- Non-Basel II approaches may complement ized and forward-looking approach to granting the framework. (For example, to address credit may also be factors that help reduce the pro- small banks' concerns over the complexity cyclicality of credit. and costs of implementing Basel II, the Hong Some common practices observed in the past, Kong Monetary Authority has developed a such as debt rescheduling to avoid early recogni- "basic approach" for credit risk which is a tion of credit risk, or government policy-directed modified version of Basel I with slight defini- lending, leading to credit decisions based on fac- tional changes and the incorporation of an tors other than sound risk evaluations, need to be operational risk charge.) overcome in order to implement Basel II effectively. At the same time, a supervisory focus on meeting The transitional floors for the advanced ap- the specific requirements of Basel II, with the asso- proaches.165 These floors should guarantee that ciated reallocation of resources, should not distract banks only get capital relief, compared to Basel I, supervisors from more immediate concerns such once the robustness of the advanced approaches as building a strong system for day-to-day risk- has been fully ascertained. based supervision. For banks that want to gradually adopt the advanced approaches, clear provisions must be in place regarding the roll-out period to avoid Overall Framework "cherry picking"166 (that is, using advanced ap- Special attention should be paid to the following proaches when these reduce capital requirements issues: and using standard approaches in other cases). Appendix 3: Basel II Issues 197 Boundaries between retail and corporate port- total ratio of 10 percent at both the individual folios, which in some cases rely on absolute and group levels. levels and which need to be adapted to local conditions.167 According to the third quantitative impact study The impact of the implementation of Basel II on carried out in 2002 by the Bank for International supervisory resources and practices (for example Settlements (BIS), capital requirements for credit enhanced disclosure requirements, technical dia- risk in emerging economies should remain broadly logue with banks). unchanged under this approach (relative to Basel The methods that will be implemented by super- I).170 This study indicates that capital requirements visors at the outset and on an on-going basis to are likely to decrease for retail and SME171 expo- assess banks' readiness for the advanced ap- sures, while increasing for bank, sovereign, and proaches and to use Basel II inputs in their equity portfolios. supervisory practices.168 Cooperation between home and host supervisors. Pillar 1 A recent survey of East Asian banking institu- tions reveals several concerns with respect to Standardized approaches home-host supervision, including coordinating Ratings by external credit-assessment agencies home-host supervisors' requests, the significant (ECAIs) will play an important role in defining historical differences in the degree of cooperation banks' capital requirements. Supervisors will between home and host supervisors across the have to carry out thorough analyses to assess region, the role that host supervisors will play in the validation process, the likely need for institu- these ratings in light of Basel II eligibility crite- tions to report under multiple Pillar 1 approaches, ria,172 to match their ratings with the different the availability of data at the host-country level, risk buckets of the Standardized Approach, and and the lack of common definitions of "material- to regularly ensure the relevance of their initial ity" and other varying definitions (of default, for assessments. Recognizing ECAIs will no doubt example). be one of the most complex issues that supervi- sors will face when implementing Basel II. Even though the Basel II framework was cali- Risk weights for public-sector entities: Basel II brated to maintain overall capital requirements as allows regulators to treat claims on certain broadly unchanged, there could be significant domestic public-sector entities as claims on sov- changes in capital requirements between credit ereigns. This discretion should only be exercised institutions169 and banking systems. in limited circumstances and its rationale pub- Moreover, it is still difficult to assess the impact licly disclosed. Special attention needs to be paid of the advanced approaches of Basel II on capital to potential conflicts of interest, especially where requirements. This was evident from the results of state-owned banks represent large portions of the fourth quantitative impact study carried out by banking systems. the U.S. authorities at the end of 2004: Risk weights for unrated corporates: as contem- plated in the Framework, supervisory authorities Where appropriate, regulators should be ready to should assess whether the overall corporate adjust their approaches to ensure that the imple- default rates in their jurisdiction require an mentation of Basel II does not lead to unjustified increase in the standard 100 percent risk weight capital relief. for unrated corporates. Pillar 2 also authorizes supervisors to require all banks to hold more than the 8 percent recom- IRB approach mended by Basel II to accommodate local bank- ing characteristics. For instance, the Monetary Initiatives to pool data at the industry level or Authority of Singapore has decided that every with external databases173 may help to alleviate bank in Singapore will have to maintain a mini- some issues related to the availability of datasets mum Tier I ratio of 7 percent and a minimum required for the IRB approaches. However, 198 East Asian Finance Even when data are available, they often do default, and loss given default) and of the for- not comply with Basel II default and loss def- mulae used to calculate the capital require- initions. Breaks in historical time-series due ments. Particular attention should be paid to to changes in ratings systems, credit policies, concentration risk (as the supervisory formulae and parameter definitions are frequent. In used to calculate capital requirements assume complex banking groups, the multiplicity of a good diversification of bank portfolios). source systems and inconsistencies in applica- The ongoing assessment of the reliability of tion across business units and/or geography the rating system will also have to take into create further problems. account market volatility. During economi- The past volatility of the environment in cally buoyant periods with low credit losses, many East Asian countries makes the qualifi- banks might respond to their improving Basel cation and validation of IRB parameters espe- II ratios by repurchasing shares, lowering cially difficult: their capital base, or strongly increasing their exposures. Since it is quite possible that real- ­ Defaults and losses in the five years follow- ized default rates significantly diverge from ing the financial crisis were massive in banks' estimates in those periods, banks will many countries in the region, and were far have to design systems enabling them to smaller in the five years prior to the crisis. assess whether the cyclicality of the market is Using long-run averages of historical loss driving this divergence or whether the bank's data could help smooth some of these ratings are flawed. It will be particularly cyclical effects but few historical datasets important for supervisors to understand the are available. bank's overall capital strategy and how care- ­ Even in the recent period, recovery rates fully it assesses the possibility of a turn in the and losses given default have been market, particularly through stress testing. negatively affected by the level of non- performing loans in many of the banking Concerning credit risk-mitigation techniques, systems in the region. IRB banks are permitted to recognize physical col- lateral. Banks using the Foundation Internal Rat- In order to demonstrate that they are able to ings-based Approach (F-IRB) remain subject to assess, differentiate, and quantify their credit risk constraints, while those using the Advanced IRB are exposure in a consistent and credible manner, not. F-IRB banks will be allowed to recognize resi- banks also have to show that they meet demand- dential and commercial real estate as well as other ing standards concerning ratings systems and types of physical assets and receivables as eligible processes and risk management, as well as the collateral. Real-estate collateral and receivables will oversight and governance of rating systems: only allow a certain reduction in loss given default (LGD) up to 35 percent (40 percent in the case of A critical component of corporate gover- physical assets) and only in cases where there is at nance is that banks meet the so-called "use least a 140 percent over-collateralization. While the test." That is, the risk-rating parameters fact that eligible real-estate collateral can only reduce should serve as an integral part of the bank's the LGD to a minimum of 35 percent under F-IRB business activities (such as pricing or credit appears reasonably conservative by advanced indus- approval), daily operations, and strategic trialized countries' standards, in some East Asian planning and not just as a regulatory compli- countries such as Korea, Indonesia, and Thailand, ance tool. The use test should help promote losses on secured lending have sometimes exceeded the broader dissemination of a risk-focused 35 percent, suggesting that the charges under Basel II culture and decision-making process. may in some cases be insufficient to cover the risks in The stress-testing requirements appear to be secured lending in these markets. In all cases, collat- especially important for East Asian banks eral should only be recognized when the legal basis adopting the IRB approaches, both to assess the for its enforcement is effective and liquid markets reliability of the input used (probability of allow reliable valuations to be obtained. Endnotes Overview and Summary 9. The Equity Market Efficiency Indicator is a composite measure that captures transaction costs and the quality of 2. 5.1 percent excluding China. information disclosure. Transaction costs are measured by 3. These included a network of currency swap arrangements the proportion of zero-return days in a trading year. Since (the ASEAN Swap Agreement), bilateral repurchase agree- informed traders only trade when the benefits exceed the ments, the Executives' Meeting of East Asia and Pacific costs of doing so, a market with higher trading costs (both Central Banks (EMEAP), the Four and Six Markets Meet- implicit and explicit) will exhibit more days without ings, and the Asia-Pacific Economic Cooperation Finance trading--hence producing a zero return. The quality of Ministers' Meeting for financial cooperation among information disclosure is measured by an index of stock- finance ministers and central bank governors. market synchronicity, which captures the co-movement 4. Their agreement also covers the establishment of a net- among individual stock returns. A high level of co- work of contact persons to facilitate regional surveillance, movement indicates that there is not much firm-specific as well as a network of research and training institutions to information. build up the skills of officials in the financial, banking, and 10. However, China is currently undertaking major reforms fiscal areas throughout the region. to increase investors' access to shares. First, it has started 5. Financial intermediaries and markets tend to perform the to convert about US$210 billion of non-tradable "A" shares, core functions of a financial system--resource mobiliza- essentially state-held equity, into common-stock tradable tion, resource allocation, and risk management--in dif- "A" shares that can be bought and sold on the exchanges. ferent ways and each may be better at certain aspects of Companies seeking to convert non-tradable stock must these functions. Hence, they tend to be complementary (or obtain the approval of the holders of tradable shares and imperfect substitutes). Indeed, financial intermediaries offer cash or shares to compensate them for the increase and markets are also complementary in that the former are in supply. As of end-2005, 421 listed companies had key participants in financial markets and tend to play a completed their negotiations with shareholders (about supporting role in ensuring the full functioning of finan- 31 percent of the total listed companies, accounting for cial markets. 35 percent of the total capitalization of China's stock mar- 6. In addition to Hong Kong (China) and Singapore, Korea, ket). The companies that have completed the share reforms and Malaysia have developed sizable corporate bond are now called "G" share companies. Second, new rules markets. were announced in January 2006 to allow foreign investors 7. Throughout this report we try to benchmark East Asian to buy strategic stakes in tradable "A" shares. Overseas economies within the region and with peers within the same investors will be allowed to buy "A" shares using RMB, pro- income group in other regions. The latter comparison has vided they acquire at least a 10 percent stake in a firm and some disadvantages, since in general the East Asian finan- hold the stock for at least three years. Thailand has also cial systems are more developed relative to those of countries recently loosened restrictions on foreign investors. with the same level of income in other regions. Neverthe- 11. These figures are based on the International Finance Cor- less, we include in most tables data on comparator countries, poration's IFCI (Investible) return index, which includes a where data are available. The comparator countries, based on subset of the stocks included in the IFCG (Global) index. 2004 GDP per capita figures (at 2000 prices in U.S. dollars), 12. The stability indicator is a composite indicator, based on are divided into six groups: (1) Indonesia (Georgia and measures of volatility and the skewness of returns--i.e. the Ukraine); (2) China and the Philippines (Albania, Bolivia, extent to which markets are more likely to deliver large and Serbia and Montenegro); (3) Thailand (Peru, Russian negative returns. Federation, and Turkey); (4) Malaysia (Chile, Latvia, Lithua- 13. The reasoning is as follows: A corporation has more incen- nia, and Mexico); (5) Korea (Greece, Spain, and Slovenia); tive to hide bad news than good. Thus good news is (6) Singapore and Hong Kong (China) (Japan, United States, released to the public promptly, and stock market prices and United Kingdom). We also systematically benchmark adjust immediately, which makes for more gradual price with regard to industrial countries (Germany, Japan, United adjustments. In environments of poor disclosure, bad news Kingdom, and United States), which is arguably a more use- can be covered up and accumulated by management. Of ful comparison if the region's financial sectors are to position course, eventually, even bad news comes out. As a result, themselves well in the global arena. bad news is released all at once and has a much greater neg- 8. Based on standard indicators of efficiency such as the ratio ative impact on stock prices. Further, the public will of operating costs to assets and the ratio of net interest inevitably feel that the corporation is still hiding informa- costs to assets. tion and thus the reaction to the bad news is usually an 199 200 Endnotes overshooting decline. That is, a firm may deliver large neg- 23. There are moreover a number of inconsistencies even ative returns on some days, but small positive returns most among the ratings of the international agencies. In partic- of the time. ular, a study by the Bank for International Settlements has 14. Assessments of compliance with the Basel Core Principles shown a number of inconsistencies in the relationship for Banking Supervision show the need, for example, to between foreign- and local-currency ratings used by a sin- further strengthen compliance with the requirements for gle international rating agency as well as sizable disagree- evaluating asset quality and the adequacy of loan-loss pro- ments among the international rating agencies on the visions and reserves; rules for identifying the limiting con- relationship between local-currency and foreign-currency centrations of exposures to single borrowers or to groups ratings. Packer 2003. of borrowers; rules for lending to connected or related par- 24. In many countries, for instance, insurance companies are ties; and policies for identifying and managing country, allowed to offer short-term deposit-like products, while market, and material risks. Among supervisors, compli- some new types of securities products, such as credit deriv- ance with the requirements for off-site supervision, with atives, in practice bear many of the characteristics of an on-site examination, and with the conduct of consolidated insurance product. supervision is still somewhat weak. It is important that these remaining weaknesses be addressed, because they are likely to become more important as banks move into Chapter 1 new segments of lending and as the extent of cross-border participation of financial institutions increases. 25. Investors need considerable expertise to participate in 15. Derivative instruments are financial contracts whose value financial markets, which makes their participation costly in depends on, or derives from, underlying assets (such as terms of time and money. Financial intermediaries can securities or commodities) or indexes. Derivatives can be often help reduce these costs. In helping investors to par- traded on organized exchanges or in unregulated over-the- ticipate in markets, financial intermediaries contribute counter markets. to the development of markets. Empirically, it has been 16. In general, this is an area that needs to develop further in found that countries with well-developed stock markets the region; at present the base of intermediaries that can also have well-developed banks and non-bank financial develop and market financial products that suit different intermediaries--suggesting that these are complements in client funding preferences on the one hand, and investors providing financial services (Demirgüç-Kunt and Levine with varying risk profiles on the other, is limited in many of 2001). the countries. 26. The U.S. housing market provides an example. In the 1960s 17. Restrictions on pension investments exist to varying and 1970s, the housing market depended heavily on the degrees across the region, except in Hong Kong (China), health of the savings and loan industry, which, at the time, which essentially follows the "prudent person" rule typical was the predominant source of funds for housing. In par- of Anglo-Saxon countries, with ex post controls on strate- ticular, when Regulation Q ceilings curtailed the flow of gic allocations contained in scheme bylaws. funds into savings and loan institutions, there was an 18. The Philippines actually has a blend, since the Social Secu- immediate impact on housing. In the early 1990s, however, rity System is a defined-benefit plan while the Government when the US economy was recovering from the 1990-1 Service Insurance System is a defined-contribution plan. recession, the housing market bounced back strongly even 19. Just over 60 percent of Hong Kong (China)'s total assets though a large part of the savings and loan industry was (US$500 billion) and 70 percent of Singapore's total assets being closed down. By this time, both commercial banks (US$355 billion) derives from abroad, whereas generally, and the secondary mortgage market had become impor- most of the money invested in most countries' mutual tant sources of housing funds and were able to continue fund sectors derives from the domestic market. (Sources: lending despite the problems in the savings and loan Fund Management Activities 2004, Hong Kong Securities industry. (Source: speech by Thomas Hoenig, President, and Futures Commission, and 2004 Singapore Asset Man- Federal Reserve Bank of Kansas City.) agement Industry Survey, Monetary Authority of Singa- 27. Throughout this study we try to benchmark East Asian pore.) Recently, Korea has also announced its long-term economies within the region and with peers within the vision to become a regional financial hub with special same income group in other regions. The latter comparison expertise in asset management. has some disadvantages, since in general the East Asian 20. Of course, assets under management in investment funds financial systems are more developed than those of coun- may increase as a result of more sales of fund shares or tries with the same level of income in other regions. Never- units, or simply as a result in the increase in the value of the theless, we include in most tables data on comparator assets held by the funds, or as is most commonly the case, a countries, where available. The comparator countries, based combination of the two. So the increases discussed are not on 2004 GDP per capita figures (at 2000 prices in U.S. dol- necessarily the result of more sales of fund shares or units. lars) are divided into six groups: (1) Indonesia (Georgia and 21. Securitization sometimes involves the creation of deriva- Ukraine); (2) China and the Philippines (Albania, Bolivia, tive products, such as mortgage-backed securities (which and Serbia and Montenegro); (3) Thailand (Peru, Russian are option derivatives), but it can also involve straightfor- Federation, and Turkey); (4) Malaysia (Chile, Latvia, ward schemes of asset-backed securities. Lithuania, and Mexico); (5) Korea (Greece, Spain, and 22. There is, as yet, no market in East Asia for covered trans- Slovenia); (6) Singapore and Hong Kong (China) (Japan, actions of the kind that has spread prolifically since the United States, and United Kingdom). We also systematically early 1990s from Denmark and Germany. Covered trans- benchmark relative to industrial countries (Germany, actions resemble securitized deals, except in particular for Japan, United Kingdom, and United States), which is a lack of severance of ownership from the asset originator arguably a more useful comparison if East Asia's financial (Arner and others 2006). sectors are to position themselves well in the global arena. Endnotes 201 28. Although (in addition to Hong Kong [China] and Singa- ity vote of attending shareholders. pore), Korea and Malaysia have developed sizable markets 37. Members of the BOD and BOC are elected at the general for corporate bonds. shareholders' meeting. 38. This section draws on Arner and others 2006. 39. The World Bank endorsed a first set of Principles and Chapter 2 Guidelines for Effective Insolvency and Creditor Rights Systems in 2001. These principles are being revised taking 29. EMEAP is the region's central bankers' association. It cov- into account further feedback and lessons from insolvency ers Australia, China, Hong Kong [China], Japan, Korea, assessments conducted under the Reports on the Obser- Malaysia, New Zealand, the Philippines, Thailand, and vance of Standards and Codes initiative. The draft revised Singapore. principles are available at . The Bank is also working on a technical paper not required. containing more detailed implementation guidelines to 31. One of the working groups under ASEAN+3 studied the complement the Principles, and the United Nations Com- pros and cons of establishing a link among the clearance mission on International Trade Law (UNCITRAL) is final- and settlement systems of member countries. But market izing a legislative guide for insolvency. participants expressed the view that (1) the private sector 40. Secured lending can involve secured transactions using would not be interested in developing a regional facility for movable property as collateral and mortgages that use land bonds, since there was insufficient volume to make it as collateral. financially viable at that point, and the timing was not 41. At the same time, any system that involves the widespread right for the public sector to make a significant commit- use of collateral assets to support corporate lending to the ment for such a facility; (2) market participants were not point where such secured lending is used as a proxy for interested in developing a secure network that could be uninformed risk appraisal can become inefficient for the used by central securities depositories to communicate economy as a whole, both by encouraging wasteful substi- with each other and for other purposes in the region; tution of credit-risk assessments and by acting as an (3) current settlement arrangements were not a signifi- oppressive force on non-financial-trade creditors. Thus cant impediment to the development of a regional bond collateral must be available as a security to release the flow market, although there were areas that could still be of capital, but not such that it unreasonably protects ineffi- improved. ciency or excessively affects other non-financial creditors. 32. There are moreover a number of inconsistencies even 42. Personal property that is less than a freehold. among the ratings of the international agencies. In partic- 43. Article 9 of the UCC deals with transactions secured ular, a BIS study has shown a number of inconsistencies by personal property and applies to any transaction-- in the relationship between the foreign- and local-currency regardless of its form--that is intended to create a secu- ratings used by a single international rating agency, as well rity interest in personal property that secures payment or as sizable disagreements among the international rating performance of an obligation. agencies on the relationship between local-currency and 44. The Philippine Accounting Standards Council adopted IAS foreign-currency ratings. Packer 2003. and IFRS with a preface that sets forth the effective date of the standards in the Philippines and explanatory guidance, where necessary, relating to the application of the stan- Chapter 3 dards to Philippine purposes. 33. A market is characterized by adverse selection when buyers (or providers of funds) cannot observe directly the quality Chapter 4 of the good (project), while the sellers (borrowers of funds) know the quality. Sellers may offer for sale only 45. Union Bank, together with twelve finance companies, those goods that they value at less than the market price. merged with Khrungthai Thanakit and the merged entity 34. Moral hazard is created when the behavior (or actions) of was later renamed Bankthai. Bangkok Bank of Commerce a party to a contract cannot be observed by other parties. and First Bangkok City Bank were merged with Krungthai In the context of financial contracting and insurance, such Bank in 2000, and the consolidation of Bangkok Metro- behavior could lead to inefficient outcomes. Take, for politan Bank into Siam City Bank took place in 2002. example, a lending contract: if the lender cannot verify the 46. US$25 billion to the China Construction Bank and Bank of use of funds, the borrower might be inclined to take China and US$30 billion to the Industrial and Commercial actions that reduce the probability of repayment. In an Bank of China. insurance contract, the party that is insured might be 47. Tighter loan classification contributed to an increase in the inclined to put less effort into reducing the probability of reported NPL ratio of commercial banks to 7.6 percent at a loss. end-2005 from around 5 percent in 2004. 35. The specific legal and regulatory elements that are critical 48. Note that Bank Negara Malaysia defines the nonperforming- to the development, safety, and soundness of particular loan ratio in net terms. This ratio is given by (NPL minus financial-market segments are discussed in subsequent interest in suspense minus specific provisions) to total loans, chapters in the context of the relevant international and therefore differs from those in Figure 4.2, which are cal- standards and codes, because the latter include key ele- culated on a gross basis. ments that need to be incorporated into financial sector 49. However, some market estimates of these NPL ratios have legislation. been sizably higher. 36. Although there is no regulation stating this in Indonesia's 50. For example, in Indonesia, loans that have been restruc- Company Law, most companies apply a 50 percent major- tured are classified in the pass (accrual) category. In 202 Endnotes Thailand, immediately after the crisis, loans that were 60. Most of the portfolio is indexed on prime lending rates or restructured were re-classified as substandard once a debt- official inter-bank lending indices. The rates have been restructuring agreement was signed, and if three consecu- higher in Indonesia, averaging around 15-17 percent per tive payments were made they were upgraded to the pass year) due to the relative macro volatility. This prevents any (accrual) category. In the United States, by contrast, the fast expansion at least through conventional mortgage time required is six months. markets--although CPI indexed loans could significantly 51. For example, in Thailand, up to 70 percent of land and increase the affordability of these loans. 50 percent of building revaluation can be included in Tier 61. Prepayment rates in the region are relatively high (for 2 capital, but no such provisions exist in Indonesia or example, around 10 percent in Hong Kong and Korea and Korea. 15 percent in Indonesia)--in part because of competition 52. Korea's rapid expansion of credit-card financing during among lenders, and in part due to households' cultural bias 2001-02 resulted in large delinquencies for banks, but against mortgage debt. more especially for credit companies. 62. This situation exposes borrowers to significant credit risks 53. There is extensive documentation on how improper real should rates rise in the renewal phase. Risks have been kept estate financing systems can cause or amplify a broader low so far through strict equity regulatory rules, albeit to financial crisis (including as a result of lenders' myopia, the detriment of the affordability of the housing finance collateral-based and loose underwriting standards, inaccu- system. With the creation of the public secondary mort- rate appraisal methodology, inaccurate information on real gage agency in 2004, fixed-rate long-term mortgage estate markets and prices, and a lack of monitoring of key loans--to be funded by long-term MBS--are being variables such as building vacancies and land prices). promoted. 54. The growing demand has also been accompanied by a 63. Some Thai lenders do provide partial limits on the future rapid increase in housing asset prices relative to house- increase in repayments through various caps and extended hold income in the largest urban centers in China, terms. 64. The matching principle requires that the sums deriving although the trend is less visible and less of a concern at the from the issue of mortgage bonds be invested in assets that national level. In other countries, in most of the largest are capable to at least cover the claims attached to the cities, housing prices have not exceeded their 1997 pre- bonds. crisis levels, although they have been rallying steadily and 65. In countries where household and/or firm surveys are at a particularly rapid pace since 2002. available, the authors compare the predicted values with 55. Since the crisis, there has been a rise of private mortgage survey results. The findings confirm that the aggregate loan markets over specialized public lenders as seen in Korea and deposit data can be used to predict the micro infor- and Indonesia. The housing banks in the region (mostly mation with fairly good results. In Indonesia, further cor- Thailand and Indonesia) now operate as commercial banks roboration is obtained from the results of the World and are supervised as such. They cater to both the unsub- Bank/Asian Development Bank Investment Climate sidized middle income household markets (competing Assessment, which covered medium and large firms; with private banks) but also often lend to lower income 49 percent of the firms surveyed stated that they had a households (and distribute the explicit subsidies from the bank loan, so a predicted value of 39 percent for small Government for that purpose). firms seems reasonable. 56. The shift in the importance of private banks in the mort- 66. Countries in the region vary in the extent to which they gage markets is quite dramatic; for example in Korea in allow banks to undertake other activities such as under- 1998, 85 percent of the housing loans were still made by writing, brokering, and dealing in securities markets and the public National Housing Fund and the Housing Com- aspects of mutual funds, and underwriting and selling mercial Bank, while private banks were hardly active in insurance. Banks may be (1) unrestricted (all activities can the sector. By March 2005, housing loans to households be carried out directly in the bank); (2) permitted (all (mortgage and home equity loans) had become the fastest activities can be carried out but some must be undertaken growing area of lending (showing a growth of 23 percent through subsidiaries); (3) restricted (not all activities can per year between 1996-2003), and banks now dominate be carried out in the bank or subsidiary); and (4) prohib- this market; as noted in Box 4.1, over 60 percent of banks' ited (none of the activities can be carried out in a bank or retail loans are housing loans. subsidiary). China has the most restrictive policies: banks 57. Although some caution should be exercised with respect to are not permitted to engage in any way in the provision of China, since the recent portfolio has not been tested in any securities markets services or insurance services. However, recession yet and property registration and foreclosure China's new securities law passed in October 2005 leaves rights raise concerns, as do banks' underwriting policies room for integrated financial services. Indonesia and Korea and internal risk management capacities. allow banks to engage in the full range of activities in both 58. Renaud (2005). these areas but some of these activities need to be con- 59. Mortgage default insurance mitigates the "lemon" problem ducted through subsidiaries. Malaysia allows banks to as potential good borrowers are no longer penalized by engage in the full range of activities in securities (through lenders' inability to differentiate between good and bad subsidiaries) but less than the full range of activities in risks. In economics a lemon is a good whose quality is insurance. The Philippines allows banks to engage in the indistinguishable to the buyer beforehand, and which has full range of securities services directly, but to provide major flaws which render it unusable for its intended insurance services only through subsidiaries. Thailand is purpose. It comes from George Akerlof 's paper "The Mar- more restrictive, allowing banks to undertake only a sub- ket for Lemons: Quality Uncertainty and the Market set of activities in securities and insurance (both through Mechanism" 1970, Quarterly Journal of Economics 84 (3): subsidiaries). Finally, Hong Kong (China) and Singapore 488-500. allow banks to undertake directly a full range of securities Endnotes 203 activities and to provide a full range of insurance activi- quate transparency of the final beneficiary, especially in trade ties through subsidiaries. financing, affecting corresponding banking relationships). 67. Several studies have found that the cost curve is relatively 73. The Basel II Capital Adequacy Framework is designed to flat (e.g., Clark 1996; Berger and Humphrey 1991). Other both address weaknesses of the 1988 Basel Capital Accord studies have found evidence of economies of scale, but (Basel I) and to help disseminate best practice in risk man- have also found that these are reached at a relatively small agement within an integrated framework for banks, super- size. For instance, Berger, Demsetz, and Strahan (1999) visors, and other stakeholders. For details of Basel II see find that the scale-efficient size in the US is reached at $100 Appendix 3. million of assets and that the cost curve remains relatively 74. There is no set timeframe for the implementation of Basel flat after that. However, as noted by Vives (2001), a prob- II by countries whose authorities are not members of the lem that arises frequently with studies of scale economies Basel Committee. The assessment of compliance with the and cost efficiency is that they typically do not account for Basel Core Principles for Effective Banking Supervision risk. Instead they measure the effect on cost of a joint (BCP) by international bodies will be based on applicable increase in scale and risk. Noting that the lower cost of risk capital-adequacy standards, whether these be Basel I or management in a larger, better-diversified bank may Basel II. induce that bank to take on more risk, cost savings then 75. The Basel II framework is applicable on a consolidated may not be detected if taking on more risk is costly. basis and at every tier of banking groups. Its scope of appli- 68. It is impossible to assess the quality of the services cation includes financial subsidiaries, even unregulated provided. ones, with the exception of insurance companies. 69. At the same time, there can be a tradeoff between these 76. For instance, the Hong Kong Monetary Authority has the gains from competition and the stability of the banking authority to impose individual capital ratios of up to sector. In particular, it is important that the degree of com- 16 percent (compared to a 12 percent current upper limit). petition does not excessively erode the franchise value of banks and hence induce banks to take excessive risks to make up for declining profitability. In general, therefore, Chapter 5 the appropriate degree of competition is likely to be lower in the banking sector than in other sectors of the econ- 77. At end-1995, stock market capitalization had reached omy--and in practice most banking systems exhibit US$213 billion in Malaysia and US$140 billion in monopolistic competition. Thailand. 70. In China, restrictions have been loosened since 2002, when 78. By comparison, capital raised in the United States the minimum capital requirement for joint-venture banks amounted to US$54 billion on the New York Stock was reduced to US$10 billion. The revised regulations limit Exchange and US$12 billion on the NASDAQ. the shareholding of a single foreign investor to 20 percent 79. A major advantage of the Herfindhal index over standard and the combined shareholding of foreign partners to concentration measures is that it gives more weight to 25 percent of the total equity of banks. To apply for a bank- larger firms. Take, for example, two cases in which the six ing license to open branches to conduct foreign-currency largest firms account for 90 percent of the market capital- banking business, a foreign bank needs to have a minimum ization and ten firms equally account for the remaining of US$20 billion in assets. To apply for a banking license 10 percent of market capitalization. In the first case, to conduct business in local currency, the foreign bank's assume that the six firms account for 15 percent of the office needs to have an operating record of not less than market capitalization equally, and in the second case three years and two consecutive profitable years. In assume that one firm accounts for 80 percent of the market response to regulations on capital adequacy and risk man- capitalization and the remaining five firms account for agement, issued by the China Banking and Regulatory 2 percent each. In the former the Herfindhal index will be Commission in 2004, the second-tier banks have intensi- lower, at 0.1350; in the second, where one firm clearly fied their efforts to replenish capital. The increased appetite dominates, the Herfindhal index will be much higher, at for foreign and private capital has provided a new win- 0.6420. Standard six-firm concentration ratios would yield dow of opportunity for foreign banks to take equity posi- 90 percent for both cases, regardless of the fact that in the tions in banks. Thus far, 15 second-tier Chinese banks have first case, six firms are of roughly equal size and hence received foreign investment. the market could be said to be less concentrated than in the 71. Smaller banks serving local markets tend to develop closer second case, where one firm clearly dominates. relationships with their customers than larger banks that 80. However, China is currently undertaking major reforms produce more standardized products. As discussed above, to increase investors' access to shares. First, it has started however, lending decisions still need to be based on a sys- to convert about US$210 billion of non-tradable "A" shares, tematic evaluation of the credit risks posed by borrowers. essentially state-held equity, into common stock tradable 72. These gaps in meeting international standards reflect, "A" shares that can be bought and sold on the exchanges. among other things, the priority that countries are giving Companies seeking to convert non-tradable stock must to developing financial sector infrastructure; weak super- obtain the approval of the holders of tradable shares and vision; deficiencies in customer-due-diligence practices, offer cash or shares to compensate them for the increase due to lack of resources and skills; inadequate oversight of in supply. As of end-2005, 421 listed companies had com- non-bank money-transfer operators; difficulties in design- pleted their negotiations with shareholders (about 31 per- ing and implementing balanced regulations that address cent of total listed companies accounting for 35 percent of AML-CFT concerns while promoting access to finance; the total capitalization of China's stock market). The com- and underdeveloped tools for financial institutions to panies that have completed the share reforms are now identify specific risks (including potentially exposed per- called "G" share companies. Second, new rules were sons, activities related to terrorist financing; and inade- announced to allow foreign investors to buy strategic 204 Endnotes stakes in tradable "A" shares (announced in January 2006). 87. There is evidence that such skewness is associated with Overseas investors will be allowed to buy "A" shares using limited information disclosure. The reasoning is as follows: RMB, provided they acquire at least a 10 percent stake in a A corporation has more incentive to hide bad news than firm and hold the stock for at least three years. Thailand good. Thus good news is released to the public promptly, has also recently loosened restrictions on foreign investors. and stock market prices adjust immediately, which makes 81. These figures are based on the International Finance Cor- for more gradual price adjustments. In environments of poration's Investible Return Index (IFCI), which includes a poor disclosure, bad news can be covered up and accumu- subset of the stocks included in IFC's Global index (IFCG), lated by management. Of course, eventually, even bad news now managed by Standard and Poor's. Stocks in the IFCI comes out. As a result bad news is released all at once and are selected using a two-step process: first, S&P determines creates a much greater negative impact on stock prices. which securities may be legally held by foreigners, and Furthermore the public will inevitably feel that the corpo- next, S&P screens stocks according to size and liquidity. ration is still hiding information and thus the reaction to Thus, the IFCI is designed to measure the composite stock- the bad news is usually an overshooting decline. That is, a market return index of what foreign investors might firm may deliver large negative returns on some days, but receive from investing in emerging-market securities that small positive returns most of the time. Jin and Myers are legally and practically available to them (IFC 1999). 2005. Note that the degree of investor accessibility may not be a 88. Of course, liquidity in bond markets is limited even in the good proxy for the degree of actual foreign ownership: a advanced industrial countries. Even in the United States, a stock that is designated as investible may or may not be much larger market, liquidity is concentrated in govern- owned by foreign investors. ment bonds and the "benchmark" corporate bonds. Most 82. The index is designed to track the performance of liquid of the other bonds are only traded actively in the first few local-currency bonds. weeks after issuance as part of the allocation process. After 83. Broadly, liquidity is a measure of how easy it is to trade this, liquidity is typically low. Gyntelberg and others 2005. securities. Liquidity has several dimensions--tightness, 89. Liquid government bond markets are also important for depth, immediacy, and resilience (Committee on the the development of other financial segments, such as for- wards and futures to support risk-management functions. Global Financial System 1999). Tightness refers to the gen- 90. See World Bank and International Monetary Fund 2001, eral costs incurred by market participants in executing from which this discussion draws. transactions and is proxied by the difference between buy 91. An on-the-run issue is the most recently issued bond for a and sell prices, such as bid-ask spreads in a quote-driven certain term to maturity. Once a bond ceases to be on-the- market (as in the majority of East Asian countries). Depth run, it becomes a seasoned issue or an off-the-run issue. refers to the size of transactions that can be executed with- 92. Policymakers need to pay attention to the proper timing out moving prices and is proxied by quote sizes, volatility, of re-opening and buy-back operations. An on-the-run trading volumes, and turnover ratios. Resilience refers to issue may not always be the most liquid of the benchmarks. the ease with which prices return to normal after distur- Even if the lifecycle of the government security is long bances or temporary imbalances in orders. There can be enough to maintain its on-the-run status, if the time trade-offs between these dimensions. For instance, compe- between issues is too long the security may reach a point tition between market makers or regulation can narrow the where its maturity no longer corresponds to the needs of bid-ask spread at the cost of less depth, as reduced prof- the investment community. Understanding the limits of itability leads to less capital devoted to market making. continuing on-the-run issues helps the government to Jiang and McCauley 2004. decide the timing of re-openings and buybacks. World 84. The proportion of zero-return days in a trading year is a Bank and IMF 2001. basic measure of trading costs. Since informed traders only 93. Since 2004, the China Securities Regulatory Commission trade when the benefits exceed the costs of doing so, a mar- has introduced on a pilot basis a monitoring system that ket with higher trading costs (both implicit and explicit) is available to members. will exhibit more days without trading--hence a zero 94. Key agencies are: China--Zhong Cheng Xin Credit Rating, return. For further details see Lesmond and others 1999. Da Gong Global Credit Rating, and Shanghai Far East 85. This measure is part of a set being developed by the Finan- Credit Rating Company; Indonesia--PEFINDO and PT cial Sector Department of the World Bank. The composite Kasnic; Korea--Korea Investor Service (KIS), Korea Rat- indicators are comprised of sub-indicators, which are stan- ings Corporation (KR), and National Information and dardized by subtracting the median of the distribution and Credit Evaluation (NICE); Malaysia--Rating Agency scaled by the standard deviation of the distribution. These Malaysia (RAM) and Malaysian Rating Corporation standardized scores are then averaged to create the com- Berhad (MARC); Philippines--Philippines Rating Services posite indicator. Corporation; and Thailand--Thai Rating Service (TRIS). 86. In situations where the rights of minority shareholders are 95. RAM in Malaysia has one of the longest track records. weak, the controlling owners or entrenched managers are 96. The relationship between liquidity and transparency in the usually not pressured to share their private information secondary market is complex. On the one hand, if the mar- with outsiders. High synchronicity can therefore be the ket is too opaque and they cannot accurately see the cur- outcome of firms not reporting timely and reliable infor- rent market value of securities, investors may exit the mation about their real performance. Under such circum- market because it would be too difficult to accurately value stances, outside small investors usually trade on the basis of their portfolios. On the other hand, if the market is too rumors and sentiment and the stock prices of individual transparent, and the information on order flows is imme- firms are predominantly influenced by the general market diately disseminated, some large investors may be deterred sentiment. from participating in the market for fear of revealing pri- Endnotes 205 vate information. Therefore it may be desirable to protect the development of securities markets. It too finds that the anonymity of market participants when disclosing those characteristics in the law that promote private mon- transaction information. itoring and enforcement matter more than those of a pub- 97. Gyntelberg and others 2005. lic nature. 98. Korea has also recently established bond-pricing compa- 107. See Grose and Friedman (2006) for a full discussion, from nies to help address valuation issues and allow mark-to- which this section draws. market practices for bond-holding institutions. 108. Japan has JASDAQ and the Mothers' Market--the second 99. Margin purchase takes place when an investor can borrow section of the Tokyo Stock Exchange. money from a broker to purchase a stock. Short selling 109. It is important to distinguish disclosure requirements for takes place when a seller can sell a stock that he/she does making an initial public offering and for subsequent share not own or when any sale is completed by the delivery of a issues, as well as the ongoing financial and significant- security borrowed by the seller. event disclosures that are mandated by law, regulation, or 100. In a margin purchase, losses are limited to the purchase the operating rules of the exchange. price the margin ratio, whereas gains are unlimited, at 110. The development of the stock exchange promotes venture an unlimited sale price the margin ratio minus the pur- capital development. This is one reason why venture capi- chase price. In a short sale, losses are unlimited, at an tal and stock market development tend to be positively cor- unlimited purchase price the margin ratio minus the related. Another is that the infrastructure and the sale price, while the gains are limited to the sale price the investment culture created with the development of an margin ratio. This section draws on Endo and Rhee 2005. exchange are also important for venture capital. 101. See Endo and Rhee 2005, from which this discussion 111. Thailand reached a different view on the benefits of demu- draws. tualization. A steering committee set up by the Ministry 102. The margin requirement is the minimum deposit required of Finance recently recommended against demutualization of an investor and is usually expressed as a percentage of on the basis that the government would more easily be able the total of the market value of securities, cash (if any), and to implement capital market reforms, including improved the debit balance (credit extended) in a margin account. governance requirements for the exchange, if the exchange continued to be operated as a national body rather than 103. Lending and borrowing of unspecified stocks is known as being controlled by private-sector interests. However, the equity repo. governance structure was changed by including the 104. As discussed in Chapter 2, a key contribution of the Asian appointment/election of non-members to its board of Bond Fund 2 initiative is in identifying and addressing directors. some of these impediments. 112. See "Experience of Malaysia in Transitioning from Merit- 105. The issue of minority shareholder rights is likely to be par- based Regulation to Disclosure-based Regulation." Paper ticularly important in Indonesia and the Philippines where prepared by the Malaysia Securities Commission, pub- the percentage of closely held shares among the listed com- lished in Dalla 2006. panies amounts to 30 and 40 percent respectively. The per- 113. As in the case of the Basel Core Principles for Banking centages of closely held shares in the other countries are: Supervision, there are certain preconditions for effective 28 percent in China, 28 percent in Hong Kong (China), securities regulation. Thus the IOSCO principles recognize 10 percent in Korea, 17 percent in Malaysia, 25 percent in that securities law and regulation cannot exist in isolation Singapore, and 21 percent in Thailand. This is significantly from the other laws and accounting requirements of a higher than the U.S. rate at 1.5 percent, Canada, 2 percent, jurisdiction. In particular, there must be an appropriate and the U.K. rate 3.3 percent. and effective legal, tax, and accounting framework. 106. One of the arguments put forward in the academic litera- 114. The Financial Sector Assessment Program (FSAP) is a joint ture is that securities laws are needed because contract and IMF-World Bank effort designed to increase the effective- tort law alone are insufficient to reduce moral hazard and ness of efforts to promote the soundness of financial sys- to prevent promoters (issuers and intermediaries) from tems in member countries. It is supported by a range of cheating investors, because the payoff from cheating is too experts from national agencies and standard-setting bodies high and because private tort and contract litigation is too and seeks to identify the strengths and vulnerabilities of expensive and unpredictable to serve as a deterrent. This the financial system, determine how key sources of risks are hypothesis has also been empirically tested. For example, being managed, and ascertain the sector's developmental La Porta and others (2006) have studied the effects of and technical assistance needs. whether the law mandates the disclosure in prospectuses of 115. For example, China requires corporate bonds to have bank particular information such as profitability and owner- guarantees. Once guaranteed by a bank, the product is no ship structure; and whether the law specifies the liability longer a standard corporate debt but becomes akin to a standards that face issuers and intermediaries when high-yield deposit at a commercial bank. Investors are less investors seek to recover damages from companies that fol- likely to undertake appropriate credit analysis in such a sit- low affirmative disclosure but fail to reveal potentially uation. material information. Based on an analysis of 49 countries 116. Measured in terms of GDP. In absolute size, Korea and across the world, they find evidence that securities law cov- China have larger securities markets than Singapore. ering these aspects matters for the development of securi- 117. Bond markets in China, Korea, and Malaysia are larger in ties markets. The indexes reported in Table 5.11 are a absolute terms; the latter are also larger as a percentage of composite measure of disclosure and liability standards GDP. from La Porta and others (2006). A study by Djankov and 118. As a percentage of GDP they are comparable to those of others (2005) has taken the same approach to test which the United Kingdom and Germany although they are still aspects of anti-self-dealing regulations matter most for much smaller than that of the United States. 206 Endnotes 119. China's equity market, despite the decline since 2001, is still the incentives that high contribution rates may create for the largest in absolute terms. evasion. 129. In Hong Kong (China), for MPF schemes, the "prudent person" rule typical of Anglo-Saxon countries is essentially Chapter 6 followed, but it is qualified by a number of legislative rules set out in Schedule 1 to the MPF about permissible invest- 120. The original objective of the CPF was to provide for old age ments (although no quantitative limits are set). ORSO but, over time, retirement savings in the CPF have been schemes are subject to fewer restrictions. used for other needs. The first step in the move to funding 130. The Philippines actually has a blend, since the Social Secu- other needs came in 1968 when the Public Housing rity System is a defined-benefit plan while the Government Scheme enabled members to pay for subsidized public Services Insurance Scheme is a defined-contribution plan. housing built by the Housing Development Board. At pres- 131. These reforms aim at: (1) reducing the accounting differ- ent there are more than 15 savings schemes including for ences between employer pensions as reported in company insurance, home ownership, and other purposes. accounts and as reported in national accounts; and 121. Readily available information on actual asset allocation by (2) improving the consistency of national-accounting rules pension schemes is often limited to the main scheme only. for all pensions in all sectors. Moreover, accumulated pub- Moreover, the information is sometimes only available at lic pension rights represent claims on government rev- a very aggregated level, which does not allow for a detailed enues and/or assets and eventually on future GDP. analysis of the types of instruments in which funds invest. 132. It is unclear whether mandatory defined-contribution 122. While an argument can be made for pension funds to have schemes with no explicit guarantees have, de facto, some more diversified portfolios, equities should not necessar- implicit guarantees. Probably it is fair to say that in any ily form as large a share as they do in Canada or Ireland country with a mandatory pension scheme, the policy (around 60 percent). The optimal portfolio composition objective is to maintain adequate replacement rates that are should be determined by the term structure of the liabili- not jeopardized by high volatility of returns or by low per- ties. The benefit of having stocks in the portfolio is also formance. Therefore there is implicitly some liability obli- linked to whether mean reversion exists in equities--an gation to be met. issue that is being hotly debated in the academic litera- 133. A laddered bond portfolio is a portfolio of bonds with ture. staggered maturities so that a portion of the portfolio 123. Obviously, a decision to increase contribution rates would matures every year. It is a way of transforming a stock of assets into a stream of income to follow a similar liability have to be primarily justified from the perspective of pattern. ensuring the sustainability of the pension funds them- 134. A credit-default swap requires the seller of the protection selves, the benefits for capital market development being a (e.g., an insurance company or pension fund) to pay the secondary consideration. purchaser of the swap if the underlying corporate bonds go 124. The statistics also show a marked difference between the into default. number of members and active contributors (only 77 per- 135. Two main approaches to the regulation of capital and sol- cent of members are active contributors). This is not due to vency are in common use around the world and in the evasion but to the fact that any individual who has ever region. The first approach, modeled largely on the exist- contributed to the system, including retired individuals, is ing European Union "index-based" regime, is applied in counted as a member. China, Hong Kong (China), Korea, Malaysia, and Thai- 125. By contrast, taxed-taxed-exempt (TTE) and exempt-taxed- land. The second, modeled largely on the U.S. "risk-based taxed (ETT) are comprehensive income-tax regimes that capital" approach, has been applied in Indonesia. Singa- tax income equally regardless of source, and treat equally pore also has a risk-based approach that strikes a balance the different uses that income may be put to (whether con- between the two approaches (see Appendix Table 6.1 for a sumption or saving). summary of capital regulations). 126. Although payments out of some voluntary contributions 136. The asset-management industry is defined as the manage- would be taxable if they were to exceed a prescribed vesting ment of pooled capital on behalf of investors with the scale. objective of providing investors with a rate of return over 127. In the OECD countries, the tax treatment of pension sav- a certain term in accordance with a pre-set strategy. It ings mainly follows the EET rule: private pension savings includes the activities of professional fund managers man- are deductible from the income-tax base and the accrued aging various funds such as mutual funds, investment trust return on investment is exempt from taxation, but pension funds, money-market funds, and real-estate investment benefits arising from these savings are taxed. trusts. 128. How much of a pensioner's lifetime earnings should be 137. Of course, assets under management in investment funds replaced by a pension system generally depends on a num- may increase as a result of more sales of fund shares or ber of factors such as access to housing, health, and other units, or simply as a result in the increase in the value of the basic services, and the average propensity to save, as well assets held by the funds, or, as is most commonly the case, as a country's per capita income and overall level of devel- a combination of the two. Hence the increases discussed opment. An initial target for net-of-tax income replace- are not necessarily the result of more sales of fund shares or ment from mandatory systems is likely to be around units. 40 percent of real earnings to maintain subsistence levels of 138. Hong Kong (China) and Singapore have set out to become income in retirement. While higher replacement rates major regional centers for asset management, including might seem desirable, they come at a cost. The direct cost is investment funds. Just over 60 percent of the Hong Kong through higher contribution rates that might compete (China) total (US$500 billion) and 70 percent of the Sin- with other more pressing needs, and the indirect cost is gapore total (US$355 billion) derives from abroad. Endnotes 207 (Sources: Hong Kong Securities and Futures Commission's that have been recently introduced, the main barriers were Fund Management Activities, 2004, and Monetary Author- the lack of an issuing vehicle under Chinese law, mar- ity of Singapore's Singapore Asset Management Industry ketability of trust certificates, and bankruptcy remoteness. Survey, 2004.) Recently, Korea has also announced its long- The new measures provide the legal framework for exe- term vision to become a regional financial hub with special cuting securitization transactions: the trustee as the issuing expertise in asset management. vehicle, issuance of asset-backed securities (and not trust 139. While corporate and trust-form funds are sometimes per- securities) with limited recourse to trust assets, and perfec- ceived as offering stronger investor protection, the occur- tion requirements. But the originators can only be financial rence of scandals within forms of different legal structures institutions regulated by the China Banking Regulatory has been found to be broadly similar. Thompson and Choi Commission, and no derivatives and hedging are available (2001) conclude that "once a body of acceptable standards for securitization transactions. Also, registration does not has developed and governance structures matured to the provide for the registration of real estate, and the tax issues point where those assigned an oversight role can compel have not yet been addressed. participants to apply those standards, it becomes very dif- Indonesia enacted securitization decrees pre-1997, and ficult to demonstrate that any particular system provides securities regulator guidelines in 2002-03. better investor protection than others." Legislation changes in Korea include the 1998 Asset- 140. This is sometimes known as a supervisory custodian or a backed Securities Law, the 1999 Mortgage-backed Securi- depositary, as in the European Economic Commission's ties Law, and the 2003 Korea Housing Finance Corporation Undertakings for Collective Investment in Transferable law. Korea's Asset-backed Securities (ABS) Act did not Securities (UCITS) Directive, 85/611/EEC, as amended. address taxation issues: withholding tax, stamp duty, and 141. Another reason is that company law does not permit com- income tax. The result of the Secured Bond Trust Act is panies to continuously issue and redeem their own shares, unsecured securities for the domestic market and a dou- and in Indonesia a corporate investment fund is a ble special-purpose vehicle (SPV) structure for the inter- company. national market. If a securitization transaction involves 142. This is actually an area where problems have been experi- short-term assets, each sale of assets during the revolving enced worldwide. A recent example can be seen in Ger- period must be registered with the Financial Supervisory many where open-ended real-estate funds were able to Service. The ABS Act only allows registration of one secu- hold properties on their books at inflated values, causing ritization per SPV, with no use of a master-trust structure, problems when these assets could not be sold at anything which therefore raises transactions costs for repeated users. like that value to meet redemptions. New legislation in the Philippines includes the 2003 Spe- 143. This concern may arise anywhere; following the late- cial-purpose Vehicle Act and the 2004 Securitization Act. trading and market-timing scandal alluded to above, some Thailand enacted a Securitization Decree in 1997, an observers accused the U.S. Securities and Exchange Com- Asset-backed Securitization Act in 2003, and a Special- mission of having been in the thrall of the powerful Invest- purpose Vehicle Act in 2004. ment Company Institute. 150. A securitization is defined as a structure where at least two different stratified risk positions, reflecting different degrees of credit risk, exist, and where the risk of these Chapter 7 positions depends on the performance of an underlying pool of exposures (see paragraphs 539 and 540 of Basel 144. By comparison, U.S. Treasury bonds amount to US$4 trillion. Committee on Banking Supervision 2005). 145. A system introduced by the European Community as part 151. Capital requirements represent 8 percent of the risk- of the European Monetary System to reduce exchange- weighted assets, so that, for example, a 20 percent risk- rate variability and achieve monetary stability, as a pre- weighted asset will attract a capital requirement of cursor to the Economic and Monetary Union. 1.6 percent of the exposure. 146. This is not to suggest that OTC markets should not be 152. Gyntelberg and others (2005) mention that "local credit- developed before ETD markets--clearly many countries rating agencies do exist in Asia, and often ratings are have done this and much depends on country-specific con- mandatory for bond issues. Many such rating agencies, ditions. However, as a general principle, ETD markets are however, are quite new and need more time to develop a easier to monitor and regulate and it is important therefore historical record on which to build a reputation. While a that a level playing field is created so as to ensure that the handful of foreign agencies are active in Asian markets, development of ETD markets is not hampered. they often do not provide ratings across the full array of 147. In August 2004, Bank Negara Malaysia announced revi- bond issuers in individual countries." sions in the regulatory treatment of all debt securities 153. "Basel II and Securitization; a paradigm shift." J.P. Morgan issued by Cagamas. Most of the special treatment accorded 2006. to Cagamas was removed to accelerate the development of the ABS market and create a level playing field for all mar- ket participants. Chapter 8 148. There is, as yet, no market in East Asia for covered trans- actions of the kind that has spread prolifically since the 154. In Korea, real estate activities are permitted up to 60 per- early 1990s from Denmark and Germany. Covered trans- cent of a bank's capital. actions resemble securitized deals, except for a lack of sev- 155. This analysis was done for firms as of end-2003. erance of ownership from the asset originator. 156. Common problems resulting from not complying with 149. In China, major bank sector securitization legislation is BCP 20 are: lack of an adequate framework for coopera- expected in 2006-07; trial deals are permitted by banking tion, policy coordination, and information sharing among and securities regulators in 2005-06. Prior to the measures banks, securities, and insurance supervisors; lack of rules for 208 Endnotes consolidated accounting and consolidated financial state- for smaller institutions. ments; lack of minimum capital requirements and other 164. Both approaches are to be implemented by end-2006 prudential norms for financial conglomerates (e.g., limits according to the Basel II framework. to intra-group and large group exposures); gaps and over- 165. For instance, Basel II provides that banks using the F-IRB laps in prudential regulation; opaque ownership structure in approach will not have capital relief exceeding 5 percent conglomerates; and weak capacity of supervisors to monitor of their Basel I requirement during their first year of imple- risks in all entities belonging to a financial group, especially mentation, 10 percent during the second, and 20 percent in mixed conglomerates (commercial and financial). during the third. 157. A unified supervisory system seems to be better prepared 166. For instance, in its guidelines on adoption of the Internal- to mitigate regulatory arbitrage, because it is better pre- Ratings-Based Approach (IRB), the Monetary Authority of pared to develop and apply regulations and the supervisory Singapore (MAS) has indicated that it may permit phased process consistently. In addition, the information avail- rollouts in certain cases. However, MAS will generally not able to the integrated supervisor can be more quickly and permit a banking group to adopt IRB unless it is able to effectively utilized. do so meaningfully from its IRB adoption date. This means 158. By becoming the only contact point for entities for all that the initial rollout should account for the banking regulatory and supervisory issues, a single regulator group's most significant portfolios in terms of size and risk becomes responsible for preventing gaps in regulation and profile. At a minimum, MAS expects exposures that attract supervision. at least 60 to 70 percent of the capital requirements for IRB 159. Reportedly, the agencies that have completed the transition to transition to IRB on the IRB adoption date. It also phase from multiple to a single supervisor, such as expects a bank to complete the IRB rollout across the entire the Financial Supervisory Agency in the United Kingdom, banking group within two years, unless under exceptional have become much more attractive employers than the circumstances, such as a significant merger or acquisition. former regulators, so recruitment has been easier. Briault A prolonged or patchy rollout would suggest that the 2001. bank's risk management capability has not achieved suffi- cient sophistication on a group-wide basis. It would blur the distinction between capital and provisioning require- Appendix 2 ments as intended under IRB. (Under IRB, margin incomes and provisions cover expected loss and capital is 160. The International Financial Reporting Standards (IFRSs) expected to cover unexpected loss. The Standardized subsume and update the International Accounting Stan- Approach does not make such a distinction.) dards (IASs), which were issued by the International 167. For example, small and medium-size enterprises are Accounting Standards Committee, the predecessor to defined as enterprises having a turnover of up to 50 million IASB. The IFRSs consist of IFRSs, IASs and Interpretations euros in the IRB approach, while SA provisioning allows of the Standards. Where the IASB amends rather than the classification of corporates within the retail portfolio as replaces an IAS, the IAS number remains. Interpretations long as exposures do not exceed one million euros. of the IFRSs are issued by the International Financial 168. Validation by the institution is in all cases a prerequisite for Reporting Interpretations Committee (IFRIC). Interpreta- an assessment by supervisors. tions issued by IFRIC's predecessor, the Standards Inter- 169. Basel II may assist banks in articulating their capital defi- pretations Committee (SIC), are termed SICs. ciency and provide a sense of urgency to address the issue. It appears that some poorly capitalized banks have already engaged in fund-raising to address the implications for Appendix 3 their capital ratios of adopting Basel II. 170. These results should be taken with a degree of caution 161. Both Basel I and Basel II require banks to hold capital since they are based on information gathered in 2002, equal to at least 8 percent of their risk-weighted assets. when most banks were still at a very early stage in their Thus the capital requirements for a category of risk can be Basel II implementation. calculated by multiplying the relevant risk weights by 171. Although SMEs belong either to the retail or corporate 8 percent. 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Index accounting standards and practices, 3, Basel Core Principles (BCP) movable property, 57 61­62, 68 banking supervision, 89­90, 92, 170 mutual funds, 144 pensions schemes and, 136 Basel II, 95­99 securities markets, 113, 126, 127 securitization, 162 compliance with, 91 securitization, 159, 163 annuitization, 136 Bauhinia Program, 160 shareholders' rights, 52­54 ASEAN+3, 2, 3 boards of directors class-action suits, 54 Asian Bond Funds (ABF), 2­3, 36­37 oversight of, 11­12 clearance and settlements systems, 39, asset-backed commercial paper (ABCP), responsibilities, 49, 52­54 115, 115 168 bond markets, 3­4, 5, 6, 7­8, 23, 26­27, collateral, 74 asset-backed securities, 158 101, 109, 126 collateralized debt obligations, 158 transactions, 164 bank assets and, 28 commodity derivatives, 13, 151 asset-backed transactions, 164 constraints, 21 company ownership, 50 ATM penetration, 80 credit risk and, 20, 39 competition, 169 audit committees, 11­12 diversification, 34 policy, 86 growth, 104 competitiveness, banks, 84­89, 92­93, 95 integration, 34, 36 concessional terms, 68 bankruptcy, 59, 163 liquidity, 112 conflict of interests, 53 banks and banking, 27, 63­99 pricing, 12 conglomerates, supervision, 170­171 see also supervision, unified assets, 4, 6, 27 regional, 2­3 consolidation, 7, 63, 81, 83, 84, 93, 170 barriers, 85­86 regulations, 38 measures of, 82 branches, 80 size, 41, 102 securities and, 111 challenges, 22­23, 92­95 standards and procedures, 38­39 consumer lending, 69, 70­72 closures, 7 taxation, 39 mortgages, 71­77 competitiveness, 84­89, 92­93, 95 transactions costs, 14 contractual savings, 129 consolidation, 7, 63, 81 bonds corporate governance, 11, 46­52, 62 disclosure, 47­48, 49 covered, mortgages and, 76 challenges, 62 efficiency and health, 65­68 foreign, 106 importance, 46, 47 efficiency improvement, 84­85, 87 investment, policy measures, 43 incentives and framework, 92 efficiency indicators, 66 issuers, 105 investors and, 120 equity and bond markets and, 28 local currency and, 35 OECD principles, 51 foreign access to finance, 87­88 outstanding, 4, 27 corporations licensing, 92 branching restrictions, microfinance, 91 bond markets and, 21, 126 monitoring and supervision, 92 control, 50 ownership, 64 de-leveraging and performance, 77­79 reach, 79, 80, 81, 84­89 Cagamas, 76 financing, 1, 6, 120­122 risks, 9 capital insolvency, 55, 59 risk transfers, 170 banks', 9 lending, 77­79, 84 soundness indicators, 66 microfinance, 91 small, 120­122 stability, 89­92 Capital Adequacy framework, 9 costs. See transaction costs standards, 47­48 Basel II, 95­99 credit strategies, 89 capital markets, risk transfers, 170 derivatives, 13, 151 structural changes, empirical analysis, cash. See currency domestic, 6 82­83 central counter-party (CCP), 15 GDP and, 6 structure, 63­65 Chiang Mai Initiative, 2 markets, regulations, 38 supervision, Basel Core Principles China registries, 90 (BCP), 89­92 accounting standards and practices, 61 reporting infrastructure, 51 banking services, 169 banks and banking sector, 64, 65, 69 risk assessment, 20 access and usage, 79, 80, 81, 89 Company Law, 52­54 risks, 9, 170 availability, 90 insurance, 138­139 risks, bond market and, 39 policy, 89 mortgages, 72­73 risks, securitization, 164­165 213 214 Index credit-information systems, 49 economic growth, 1, 2 structure, 4, 27 elements, 50 economies of scale and scope, 7 financing requirements, 1 legal and regulatory framework, 50 efficiency, 3, 7­8 firms, listed, 104 ownership, 50 banks and banking, 65­68, 84­85, 87 fixed-income funds scope of coverage, 50 equity markets, 8, 106­108 Indonesia, 147 creditors securities markets, 11, 110­120 Korea, 145 information availability, 48­49 enforcement, 46, 53, 155 foreign direct investment, 30 insolvency and, 60­61 financial standards, 61­62 foreign entities, 7 rights, 54­55, 58, 60­61 mutual funds, 146­148 access, 104 secured and unsecured, 58 secured rights, 58 assets and liabilities, 30 credit-rating agencies, 12, 20, 113, 166 entry and exit restrictions, 86 banks, 93 rationale and feasibility of regional, 20, BCP, 92 entry and influence, 87­88, 92 41­42, 39 foreign banks, 87­88 governance, 93 standards, 3 equity derivatives, 13, 15, 151 taxation, 39 credit risk equity markets, 3, 6­7, 10, 101 foreign exchange, 38, 157 capital requirements, economic risks bank assets and, 28 access regulations, 38 and, 168 capitalization, 4, 27 derivatives, 13, 15, 150­151, 166 management, 9­10 efficiency, 8, 106­108 free-rider problem, 25, 26 cross-border banking, BCP, 92 growth, 26 futures exchange, 152­153 currency integration, 33­34 bonds and, 35 liquidity, 106­108 derivatives markets, 157 regulations, 38 gain-recognition, securitization, 162 markets, 13, 15, 153 returns, 32 GDP, investment and, 2 size, 102 governance swap agreements, 2 stability, 108 mutual funds, 143 exchange-rate devaluation, 165 pension funds, 136­137 exchange-traded derivatives (ETDs), 15, debt-to-equity ratio, 78, 79 150, 157 defined-benefit schemes, 136 exchange-traded funds (ETFs), 37 hedging delinquencies, 71 Executives' Meetings of East Asia Pacific costs, 38 demutualization, 122­124 Central Banks (EMEAP), 2, 36 instruments and their lack, 20 status of, 123 Hong Kong (China) deposits in banks, 69 banking competitiveness, 84 insurance, 92, 93, 94 fee-based services, 7 insolvency systems, 60 rates, 88 finance, access for smaller corporations, mortgages, 75 derivatives markets, 9, 13, 15, 43, 149­157 securities market, 120­122 movable property, 57 cash markets, 153 financial advice, 146 mutual funds, 141, 144­145 domestic, 3 financial information infrastructure, 51 pension funds, 131, 132, 133, 134, 137 elements and sequencing, 157 financial integration, 29, 41 securities markets, 126 exchanges, 156 bank claims, 30 securitization, 159, 160, 163, 163 features, 149­150 extent, 29­34 household debt, 70 infrastructure, 155­156 portfolio investments, 31, 34 housing markets, 77 investors and, 40 regional, 3, 22 key elements, 153­157 financial intermediaries legal and regulatory framework, 15, banks, 68­72 income-diversification index, 81, 82 153­157 financial markets and, 25­26 Indonesia market status, 156 linkages and, 169­170 accounting standards and practices, 61 participants, 154 products, 21 banking competitiveness, 85 post-financial crisis, 150­153 financial markets banks and banking sector, 64, 65, 67, products and turnover, 151 assets, 26 69 risk mitigation, 166­167 effectiveness, 4 insolvency system, 59 stylized elements and sequencing, 157 intermediaries and, 25­26 institutional infrastructure, 53­54 taxes, 156 today, 3­10 lending, 70, 71 disclosure, 12 financial reporting, 12, 62 mortgages, 72, 74 banks, 47­48, 49 standards and practices, 68 movable property, 57 equity markets, 106 financial sector mutual funds, 147 investors, to, 144­145 agenda, 10 securities markets, 126, 127 listed firms, 47, 48 assets, 4, 27 securitization, 163 requirements index, 121 financial services shareholders' rights, 54 shareholders and, 46­47 demand, 1 information, 25­26 diversification, 3­4, 25­28 range, 1­2 creditors and, 48­49 benefits, 25­26 financial systems, 22 dissemination, 47 pension investment allocations, attributes and underpinnings, 45­46 exchange, 93 134­138 risks and stability, 9 financial markets and, 45 Index 215 pricing securities, 110­114 Jakarta Stock Exchange rules, 53­54 liquidity, 7­8, 13, 21 sharing, 41, 43 judicial decision making and enforce- enhancement, 112 see also disclosure ment, 59 equity derivatives vs cash markets, 154 infrastructure funding, securitization, 162 mortgages, 76 insider trading, 53 mutual funds, 142 insolvency systems, 58­59 Korea, Republic of risks, 165 creditor rights and, 55, 60­61 accounting standards, 61 securities market, 102, 106­120 Korea, 59 banks and banking sector, 64­65, 67, listed firms, 104 institutional infrastructure, 3, 22, 45­62 69, 84 loans. See lending derivatives markets, 155 bond markets, 113 microfinance, 91 capital adequacy, 99 institutional investors, 3, 22, 129, 130 Corporate Code, 54 Malaysia assets, 15­16, 27, 28 insolvency systems, 59­60 banking competitiveness, 84­85 instruments that appeal to investors, institutional infrastructure, 53, 54 banks and banking sector, 65, 67, 69 18­20 legislation, 148 bond market, 104, 112, 113 insurance, 17, 18 lending, 71 disclosure system, 125 life insurance, 17, 129, 130, 139, movable property, 57 insolvency systems, 60 140­141 mutual funds, 145 lending, 71 penetration and density, 17 pension funds, 129­130, 132, 133, 135, mortgages, 76 risk management, 17 137 movable property, 57 insurance sector, 138­139 securities markets, 126, 140 mutual funds, 144 assets, increasing, 138­139 securitization, 159, 160, 163 pension funds, 130, 132, 134, 135, indicators of concentration, 140 shareholders' rights, 54 137­138 indicators of development, 139 KOROmas Fund Ltd., 160 securities markets, 126, 140 investment regulations, 141 securitization, 160­161, 163­164 risk and risk transfers, 170 managerial issues, unified supervision, integration legal and regulatory systems, 3, 13, 15, 18, 173­174 gains from, 20­21 20, 38, 43, 45, 62, 90 margin trading, accounts, and lending, regional initiatives and, 34­37 challenges, 23 116, 119 interest coverage, 78 consumers, 69, 70­72 markets interest rates corporate, 6, 77­79 capitalization, 26 microfinance, 91 corporate insolvency, 59 discipline, Basel II, 98, 99 risks, 165 credit-information system, 50 linkages across, 169­175 derivatives, 13, 15, 151, 157 demutalization and, 123­124 practices and infrastructures, differ- intermediaries derivatives markets, 15, 153­157 ences, 20 banks, 68­72 disclosure-based vs merit-based, risk, 170 financial markets and, 25­26 124­125 surveillance, 155 linkages and, 169­170 enforcement, 18, 46, 146­148 Mexico, securities law, 122 products, 21 insurance, 141 microfinance, 79­81, 84 internal assessment approach, 168 investors, 120 enhancing-environment, 91 internal-ratings-based approach (IRB), IOSCO principles, 125­126 money laundering, combating, 95, 96 167, 168 International Organization of Securities lending and loans mortgage-backed securities (MBS), Commissions (IOSCO) principles, mandates, 148 76­77, 158, 166 125­126 margin, 119 mortgages international reserves, 1 microfinance, 91 debt, 72 intra-regional trade, 2 mortgage lending, 74, 75 default systems, 74, 77 investment rate, 1 mutual funds, 141­143, 144­148 interest rates, 75 GDP and, 2 non-performing loans (NPL), 9, 65, market requirements, 73­74 investments 67­68 maturities, 74­75 alternative markets, 121­122 regulators, 147, 148, 171­172 residential lending, 71­77 asset-class exposure, 142 relationship-based vs rules-based, 89 sale of, 163­164 cross-border, impediments, 37­39 residential mortgages, 72­77 movable property, treatment of, 57 products, 18 risks, 165­166 mutual funds, 17­18, 25, 140­141 investor base, 23 securities markets, 116, 121­126 development elements, 141­148 broadening, 15­18, 120 securitization, 19, 162, 163­164, 167 governance structures, 143 strengthening, 129­148 unified supervision, 173, 175 pricing of shares, 144 investors liability confidence, 18, 143­146 -based management, 135­136 equitable treatment of, 144 standards index, 121 netting, 155 institutional, 3, 22, 15­16, 27, 28, 129, licensing, 90 non-bank financial institutions, 21 130 microfinance, 91 risk and, 9­10 instruments that appeal to, 18­20 life insurance, 17 non-performing loans (NPL), 9, 65, rights of, 144 linkages across markets, 169­175 67­68 216 Index operational risks, 166 information sharing, 41­42 regulatory and supervisory framework, over-the-counter (OTC) derivatives, 15, new areas, 39­44 122­126 150­153, 157 regions settlement, 115 changing context, 1­3 strategy, 111 initiatives to enhance integration, trade reporting, 113­114 Pan Asian Bond Index Fund (PAIF), 37 34­37 transactions costs, 12­13, 15, 114­116, partially unified agencies, advantages and regulation. See legal and regulatory 119 disadvantages, 172 systems securitization, 18­20, 21, 23, 122 pension funds, 16­17, 129­132 regulators, 147, 148, 171­172 Basel II and, 167­168 asset allocation, 131­132 remedial measure, BCP, 92 cross-border, 161­162 asset size and type, 130 prepayment risk, 165 derivatives markets, 157­158 contribution rates, 133­134 report outline and structure, 22­23 elements needed, 19, 162­168 coverage, 132­133 repurchase (repo) infrastructure funding, 162 defined-benefit, 16 agreements, 112, 116 legal and regulatory issues, 162, defined-contribution, 16 markets, 15, 157 163­164 governance framework, 136­137 reserves, international, 1 principles, 158 investment allocations, 134­138 return on assets, 78 risk and risk management, 164­167 risk management, 137­138 risk, 9­10 sequencing, 164­167 taxation, 133 -bearing capacity, 2 security interests per capita income, household debt vs, 70 diversification, 26 creation of, 56­57 Philippines monitoring, 21 legislation, 55­58 accounting standards and practices, 61 preferences, 15 registration, 57­58 banks and banking sector, 65, 69, 85 securities market, 115 rights enforcement, 58 insolvency systems, 59, 60 self-dealing securitization, 18­20 institutional infrastructure, 53 abusive, 53 sharing, 18­21, 23, 26, 149­168 investment legislation, 143 anti-self-dealing standards index, 121 transfer, 9, 20­23, 170 movable property, 57 self-interest, 53 risk management and mitigation pension funds, 131, 134, 135, 138 service-performance risk, 165 framework, 43 securities markets, 114, 126­127, 140 services, range, 25 mechanisms, 166 securitization, 163 settlement, securities market, 115 pension funds, 137­138 policy and policymaking, 3, 22, 23, 26, 29 shareholders securitization, 164­167 banking services, 89 equitable treatment, 50, 53 rules. See legal and regulatory systems environment, 88 minority, 11 measures, 43 rights, 49­54, 62 mutual funds, 146 short selling, 116, 119 secondary market, liquidity and, 111 securities markets, 102 Singa Secured Assets, 161 secured lending, 60­61 unified supervision, 174­175 Singapore secured rights, recording and registration, portfolio investments, 31, 34 banking competitiveness, 84 55 assets and liabilities, 31 futures exchange, 152 securities, 7, 109­110 equity and debt, 30 insolvency systems, 60 asset-backed, 158 prepayment risk, 165, 166 movable property, 57 instruments that appeal to investors, pricing information mutual funds, 141 benchmarking, 110­113 18­20 pension funds, 131, 132, 133­134 rating agencies, 113 pricing information, 10­11 securitization, 161, 163 securities, 110­114 securities markets, 9, 107, 101­127 sovereign risk, 165 trade reporting, 113­114 access to, 103­106 special-purpose vehicle (SPV), 158, 162, primary-dealer system, 112 benchmarking, 110­113 163, 165­166 private sector, financing, 69 challenges, 22­23 stability, 9­10 property demutualization, 122­124 foreign banks and, 88 movable, 57 developing, 10­22 staff issues, unified supervision, 173 real, 56 efficiency, 11, 110­120 standardization, securities, 111 Public Company Act, Thailand, 53 finance, access to for smaller corpora- standardized approach, 167, 168 public interest, role, 124 tions, 120­122 standards, bond market, 38­39 publicity, security interests, 56, 57 fixed income, 114 stock exchange increasing allocations to, 139­140 corporatization, 123 infrastructure, 12­13, 126 demutualization, 122­124 rating agencies. See credit-rating agencies instruments, 7, 18­20, 109­110 Stock Exchange Act, Korea, 54 ratings-based approach (RBA), 167 investor base, 15­18, 120 stock-lending system, 119 real-estate-investment trusts (REITs), lending, 116 stock market, 3, 7, 26, 101 159­162 liquidity, 107­110, 117­120 access to, 103 real property, 56 post-financial crisis, 159­162 bank assets and, 28 regional cooperation, 2, 3 pricing information, 110­114 trading fixed-income instruments, 114 credit-rating agency, 39, 41 principal dealers, 112, 113 structural risks, 165 diversification and, 29­43 rating agencies, 113 supervision, unified, 171­172 Index 217 advantages and disadvantages, 172 taxation, 20, 38, 39 equity markets, 106­107 implementation issues, 172­174 pension funds, 133 reducing, 12­13, 15 legal constraints, 173 securitization, 162 securities market, 114­116, 119 managerial issues, 173­174 terrorism, financing, 95, 96 small corporations, 120 pros and cons, 171­172 Thailand transparency, shareholders and, 46­47 staff issues, 173 banking competitiveness, 85 trusts, 143­144 time required, 174 banks and banking sector, 65, 67­68, timing, 175 69 supervisors bond market, 113 unified supervision, 171­172 roles and responsibilities, 174 insolvency systems, 60 advantages and disadvantages, 172 separate, 172 institutional infrastructure, 53 implementation issues, 172­174 supervisory framework lending, 71 legal constraints, 173 BCP, 92 mortgages, 72, 74 managerial issues, 173­174 challenges, 23 movable property, 57 pros and cons, 171­172 formula, 167­168 pension funds, 130­131, 132­133, 134, staff issues, 173 IOSCO principles, 125­126 138 time required, 174 practices, 21 securities markets, 140 timing, 175 review process, Basel II, 97, 99 securitization, 163 unsecured creditor rights, 58 securities markets, 125­126 shareholders' rights, 53 trends and issues, 170­171 stock exchange, 114 supply-side issues, 2, 3, 37 trade reporting, 113­114 venture capital, 122 swap-counterparty risk, 165 transaction costs, 38 volatility spillover coefficients, estimates swaps, 166 bond markets, 14 for, 33 W ell-functioning financial markets are critical for supporting East Asia's ambitious growth and development agenda. Over the coming years, East Asia's financial sector will n d to be highly diversified to m t the n ds of increasingly complex and sophisticated economies. It will n d to provide financial services efficiently, and it will n d to be robust to withstand potential shocks in a fast-chan ng, globalizing world economy. Since the 1997 financial crisis, East Asian economies have made significant progress in strengthening and diversi ing their financial markets. But sizable challenges remain in the main segments of the financial sector: banking, equi , and bond markets. East Asian Finance: e Road to Robust Markets provides a comprehensive overview of the financial markets in the East Asia re on. It undertakes a systematic analysis of each of the financial segments in terms of access, efficiency, and stabili , and discusses the remaining challenges and policy priorities. It argues that the East Asian economies n d to focus on further developing the securities markets. In particular, ven the depth of the financial sector overall, economies in East Asia lag behind in the relative importance of the bond market. e text discusses the critical policy agenda to further develop these markets, both at the re onal and domestic levels. e book will be useful for policy makers, market participants, and development practitioners, as well as for researchers and students. ISBN 0-8213-6743-9