REWARDS AND CHALLENGES FOR BANKS AND POLICYMAKERS IN THE CONTEXT OF INCREASING FINANCIAL INTEGRATION IN ASIA

Ladies and gentlemen, thank you very much for inviting me to speak at this year’s Asian Banker Summit. I am very pleased I could join you here in Jakarta. As you know, the International Monetary Fund has a keen interest in financial sector issues in the rapidly developing Asian region. Congratulations  also for organizing such a comprehensive conference on risk management and governance.

The world is changing rapidly, and Asia is a key participant in these changes. From the financial markets perspective let me mention three important structural changes that are taking place: the growing integration and new role of emerging market countries in the global economy; the growing innovation, sophistication and complexity of financial markets and risk management; and the third is the increasingly important interaction between the financial sector and the real economy. This interaction that is not only stronger but also more complex and global. The result is more opportunities and also more challenges.

Against this backdrop, today, I will speak about the challenges and opportunities of banks in the context of the increasing financial integration in Asia.

If I had to summarize my presentation today, I would do it in two basic equations:
INTEGRATION  + APPROPRIATE  FRAMEWORK AND POLICIES =
=GROWTH + FINANCIAL STABILITY FOR THE ECONOMY

As you can see I mentioned “Integration” twice.  Perhaps I should explain why I think integration is so important. In addition to theoretical arguments and empirical evidence, I come from Spain, a country that has benefited enormously from integration, in our case from European integration. The dynamics of the process created more opportunities than any could anticipate and the financial system became stronger and more profitable.

We thought that integration was the proper answer to rapid globalization. We embraced the idea that further integration was not the problem but the solution, and this idea was able to catalyze changes and reforms in the right direction. This is one of the reasons why I think that integration, properly managed, brings tangible benefits. Asia’s financial integration with the world is well advanced and important steps had been taken to deepen regional integration and economic cooperation.

Asia is a region featuring very dynamic economies, which have enjoyed high and stable growth rates recently. Growth in emerging and developing Asia has averaged approximately 9 percent over the last few years. Meanwhile, inflation has remained broadly in check. Asia’s growth performance has benefited from rapid productivity increases. These productivity increases in turn have benefited from high standards of education, so as to support skill- and innovation-based industries and move up the value-added chain. At the same time, large investments in physical infrastructure have taken place. Still, infrastructure bottlenecks remain a barrier to investment in a number of countries. The World Bank recently estimated that $2.5 trillion must be spent over the next decade to improve the region’s infrastructure. The financing of investment on this scale will present a challenge to the authorities and financial systems in the region. Thus, the continuation of strong growth performance will require substantial investment, including in infrastructure, which will need to be financed.

At the same time, the relatively high savings in the region present an opportunity to gain substantial benefits from further improvements in financial intermediation. Savings rates in developing Asia as well as in the newly industrialized countries in Asia stand at well over 30 percent of GDP on average over the last 10 years; significantly higher than the world average of slightly above 20 percent. This amounts to over $2 trillion in savings annually. Much of these savings flow to developed economies, often in the form of holdings of government paper of advanced economies. A significant part of these funds are subsequently recycled back into the region in the form capital inflows, sometimes more volatile. Boosting the level of regional financial intermediation would present an opportunity to improve both growth and stability.
 
While changes in macroeconomic policies are key in addressing this issue, improved intermediation of savings in the region by building stronger financial systems and increasing integration will play an important role as well. Large, open, and integrated financial systems generally bring a number of benefits, including greater competition and efficiency of financial institutions, product innovation, lower cost of capital, longer maturity of financing, greater diversification of risks, greater liquidity in traded securities, increased transparency, and more sophisticated risk management. More efficient financial intermediation leads to a better allocation of risks and resources, which in turn delivers higher average growth rates. In Europe, the European Central Bank estimates that the integration of the bond and equity markets alone has contributed over 1 percent of GDP, or approximately € 100 billion, over a ten year period. Overall, financial integration can help a country develop its financial sector, making resource allocation more efficient and the economy more resilient to shocks. At the same time, financial integration carries risks that must be anticipated and managed.

What is the current state of integration of financial systems in Asia? While trade openness, as measured by the ratio of goods and services trade to GDP, has increased in nearly all countries in Asia and, on average, is higher than in most other regions of the world, regional financial integration has been more sluggish. Although Asia’s financial integration with the world is well advanced by some measures, including net private capital flows, foreign participation in some markets, and stock market correlations, the picture is mixed if we use other measures. For example, total financial liabilities in Asia are typically lower than in other regions of the word. Asia’s foreign portfolio liabilities and assets are limited in terms of GDP and accrue mainly to the EU15 and North America, while for example the EU’s (in relative terms much larger) foreign liabilities and assets mainly originate in the EU itself. Moreover, intraregional financial integration, measured, for example, directly by cross-border capital flows or indirectly by cross-border correlation of consumption growth, has been more limited than elsewhere.

• Promoting greater financial integration will require time and the process needs to be carefully managed, but the potential welfare gains are substantial.  Increasing the efficiency of financial intermediation through greater openness and financial integration will take time and will require much work. Moreover, as can be seen from developments in the European Union, the integration process will likely not evolve in a linear or even continuous fashion. Also, there are risks associated with greater integration as well as the implementation process. These risks need to be carefully managed—a strong framework for prudential regulation and risk-based supervision are instrumental in this respect. But the potential benefits are large, as I already outlined.

Implications for Banks in Asia

What implications would greater integration have for banks in Asia? I believe there are three main issues: (i) integration will lead to greater competition and therefore pressure to improve efficiency, (ii) strong and well-managed banks will have greater opportunities for growth, and as a consequence risk management will become an increasingly strategic element to improve the competitive advantage of banks; and (iii) greater integration will bring new risks that banks will need to learn to manage properly.

Banks will face greater competition as the industry becomes more liberalized. Greater competition will likely put pressure on margins and force banks to innovate more and try harder to meet the needs of current and potential clients. Possibly slimmer margins on existing business may also strengthen the need to focus on greater efficiency of operations. It is possible that such a focus will stimulate a consolidation process in some countries that have a relatively fragmented banking systems. Looking to the Euro area for examples, the number of credit institutions has decreased by about a third since 1995. However, as competition has increased simultaneously, this consolidation process does not seem to have resulted in a reduction in small business lending.

At the same time, banks will have the opportunity to expand in the region, which may bring diversification benefits and economies of scale. The flip side of removal of restrictions and greater competition is the opportunity for strong and well-managed banks to expand in the region. If properly managed, such expansion may bring substantial benefits to the bank and its shareholders, including from diversification and economies of scale. Indeed, the forthcoming Global Financial Stability Report published by the IMF explores globalization of financial institutions and suggests that cross-border diversification may be more beneficial than functional diversification, also because of imperfect correlation of economic activity across countries. Again bringing up the case of the Europe, the European Central Bank found that even under adverse conditions, the EU banks’ return on equity and loan loss provision did not suffer much. It seems that consolidation has contributed to greater resilience of banks to some extent, as in the consolidation process weaker institutions have generally been acquired by bigger and stronger rivals.

In a more integrated financial system, banks will face new risks and will hence need to improve their risk management. For example, greater volume of cross-border business will likely bring greater risk of currency mismatches. Also, greater cross-border intermediation will expose banks to new sources of credit risk, which the banks may not be fully familiar with. Banks will need to work hard to ensure that these and any other new risks are well managed.
In this new world of finance, in a continuous process of innovation, where capital flows are growing rapidly, the transfer of risks are growing even more rapidly and the financial instruments are becoming more and more sophisticated. In this world, there are two risks that are gaining prominence: operational risks and reputational risks.

Improved risk management systems in large international banks will need to be based on an integrated view of risks, as well as be tuned to country-specific circumstances and structures. A comprehensive firm-wide assessment of risk and consistent reporting helps to ensure that the firm understands the relative importance of various risks and how they may interact, and this facilitates early detection and resolution of problems. This integrated risk management function requires a balance between the centralisation of some functions within the group as a whole, and the need to be close to local markets to incorporate better knowledge of local needs, risks, sensitivities and regulations. This, in turn, raises issues of co-ordination and communication for both internationally active banks and also supervisors, and  may also help alleviate the concern of authorities in some countries that global players do not take decisions in the best interest of the local economy.

In such a setting, with increased financial integration, state-of-the-art risk management can become an important competitive advantage for banks. The institutions with the best risk management will find the most opportunities for growth. It is precisely these institutions that will be most successful in this environment. Therefore, the ongoing implementation of Basel II in many Asian countries should not be viewed as just one more regulation banks need to comply with, but as an opportunity to develop better risk management systems and gain a competitive advantage.

To make this happen, a proper risk management framework must include: a comprehensive firm-wide analysis, integration and quantification of different risks. It requires also systems, technology and telecommunications. And most importantly it requires enhanced governance and control systems. From board involvement and establishing dedicated risk management functions to building efficient management information systems across all businesses lines, on the basis of common measures of risk.  
The quantification and integration of various risks in a more rigorous and more consistent is also very important. Using the concept of economic capital, banks can develop sound policies for monitoring exposure limits, risk-adjusted pricing policies and sound provisioning practices based on the inherent risks of the portfolios. They can also measure returns and assign capital on a risk-adjusted basis.
Let me add a word of caution.  Despite the significant progress made in the banking industry in the use of models and new technologies, banks still depend largely on risk managers’ expert judgement. Quantifying risk involves making assumptions and judgements. And no model can replace the skills of a trained, experienced risk manager but it can provide support and help to formalize the process. Furthermore, it is important not to forget the basics; many problems in banking come from traditional problems such as: connected lending, concentration of risks, inadequate loan classification and insufficient provisioning etc.
Let me conclude this part of opportunities and challenges for banks by saying that following sound risk management, governance, and disclosure practices is a crucial contribution of financial institutions to maintaining the confidence and integrity of capital and financial markets and to make financial systems stronger.

Challenges of Promoting and Managing Greater Integration

So what should be done to achieve greater integration and manage related risks? The three main areas that need to be addressed if greater integration is to be realized and benefit the economies in the region are: (i) building deeper capital markets and stronger financial institutions; (ii) preparing the regulatory and supervisory systems for new challenges; and (iii) removing obstacles to integration. I will discuss these in turn, but I first I need to clarify three general points:
First, Asia in not a homogenous region and reforms must recognize the diverse state of development of Asian economies and should be adapted and sequenced to country-specific circumstances;
Second, these reforms are interlinked. For example, steps to build strong market infrastructures among economies to encourage intraregional investment will not be effective if there are regulatory impediments that discourage cross-border activities; and
Third, many, if not all, the areas for reforms are well-recognized and Asian policymakers have already started many initiatives to address challenges in these key areas. These include steps to create regional Asian financial markets, such as the Asian Bond Market Initiative, the Asian Bond Fund (ABF), increased links between stock exchanges, and the Association of Southeast Asian Nations (ASEAN) Finance Roadmap; to collaborate in adopting global standards and best practices; and to establish regional mechanisms for crisis management and prevention. I only offer my own perspective on these issues.

Building deeper capital markets and stronger financial institutions

Institutional investors, corporate governance, and financial reporting are the main areas for further reforms. Asian policymakers have recognized the importance of strengthening capital markets, and many initiatives have been launched, at the national and regional level’s to deepen domestic markets and establish pan-Asian markets. What more can be done? Here I would like to mention three areas for further reforms:

• Reforms aimed at strengthening the investor base by increasing the role of institutional investors—asset managers, insurance companies, and pension funds—can have a profound impact on the development of regional capital markets.
• Strengthened corporate governance is essential for deep and liquid financial markets.
• Increased transparency and accountability through moving to a common financial reporting framework—the International Financial Reporting Standards (IFRS)—is another key reform.

In the banking sector, corporate governance requires special attention. Shortcomings in the governance of banks not only lowers returns to shareholders, but can also destabilize the financial system. Particular attention needs to focus on ensuring that related-party lending between the banks and companies associated with the bank or its owners occurs in a manner consistent with sound banking practices, and on state-owned commercial banks to avoid government interference in these banks’ commercial activities.

Preparing the regulatory and supervisory systems for new risks and cross-border flows

Risk-based supervision and the capacity to understand and effectively supervise risks more generally should be the focus of supervisors going forward. National authorities in Asia have made commendable progress in introducing risk-based supervision, although effective implementation will take time. Supervisors recognize that they have to go beyond a compliance or “checklist” based approach in supervision to one that requires a thorough understanding of an institution’s activities and its risks. Most supervisors in Asia have made progress in issuing guidelines and procedures for assessment of different risks and in developing the required databases. However, the capacity to understand risk and effectively supervise institutions will take time and experience to develop. For banking, moving toward risk-based supervision is also key for effective implementation of the Basel II framework.

Consolidated supervision is needed to deal with risks from diversified financial groups or conglomerates. Financial groups are susceptible to contagion as problems can be transmitted within the group through intra-group transactions and reputation effects. In many developing Asian countries, supervisors are still in their early stages of implementing consolidated supervision, both on a domestic and a global basis.

With deeper cross-border linkages, improved cross-border cooperation, and convergence of approaches is also increasingly important. As found in many assessments of the Basel Core Principles for Effective Banking Supervision, co-operation among supervisors in the different countries needs to be improved. Both home and host supervisors will need to work together to ensure effective oversight. Efficient cooperation and information sharing requires that each supervisor is equipped with strong risk assessment capability, clear prudential regulations, and the ability to take remedial measures. Not to overburden banks and to prevent regulatory arbitrage, some level of convergence of procedures and arrangements would be needed. Convergence and cooperation between supervisors is especially important when dealing with problems or issues faced by regionally or globally active financial institutions. This would include information sharing, global monitoring of risks, as well as coordinating remedial actions or crisis management, including lender of last resort arrangements.

• Finally transparency of the supervisors is also very important. Transparency about the goals they are aiming to achieve, as well as about the process of implementation. An open dialogue with the financial sector is instrumental in explaining these issues, learning from financial institutions and adapting approaches accordingly.

Removing obstacles to greater integration

Despite recent progress, further steps in several areas would help reduce obstacles to greater integration. Policymakers in Asia have made good progress in removing some obstacles to further financial integration, but the process is fairly complex and further steps will be needed. To mention several key issues, policy makers could relax non-prudential restrictions on the provision of financial services,  reexamine prudential limits on pension funds’ and life insurers’ investments, develop market infrastructure further, harmonize laws, regulations, and tax treatment, and aim to gradually remove obstacles to greater capital mobility.

As a general point on reforms, it is important to realize that deepening capital markets and strengthening institutions and regulatory systems needs to go hand in hand with gradual removal of obstacles.  The authorities cannot wait until they have the perfect systems in place; financial institutions need to learn manage new risks gradually.

Summary and Conclusion

• Ladies and gentlemen, against the background of increasingly sophisticated risk management practices, heightened complexity in the financial markets and stronger interaction between the real and the financial economy, I have spoken about financial integration in the Asian region and about the importance of risk management. I have highlighted some of the challenges further financial integration presents, both for bankers, as well as for policymakers. But I have also tried to emphasize that the potential rewards are large both for the economies of the region and for the financial institutions.

Ladies and gentlemen, I would like to thank you for your attention..