Jan 12, 1998

FINANCIAL LIBERALISATION & BANKING RISKS

BY ANDREW CORNFORD AND JIM BRANDON*

Geneva, Jan (TWN) -- Financial deregulation and opening-up are species of structural economic change, and mostly require significant periods of time if their benefits are to exceed their costs.  

Thus unsurprisingly in OECD countries deregulation and the associated longer-term changes in the functioning of financial markets typically have frequently taken place over extended periods of time.  

According to an 1989 OECD study on competition in banking, 11 of a sample of 20 countries actually completed the deregulation of interest rates by 1987.  

For some the periods lasted only one to two years (Canada, Ireland and Germany), whilst in others it lasted seven to 15 years (Sweden, Norway, Denmark, United Kingdom and Finland) or 16 to more than twenty years (Spain, Australia and New Zealand). Nine of the 20 had yet to complete the process by 1987-88. 

The creation of a single market for financial services in the EU also sheds light on problems facing other initiatives to liberalize international transactions in such services, including those in the WTO.

The EU process began with the founding of the EEC in 1957, but the legal framework for the single market took more than 30 years to be put in place.  

There were several reasons why the process was so lengthy: many of the problems entailed could not be properly anticipated in advance and thus had to be faced and solved as they emerged in particular contexts; the banking sector had been traditionally regarded by governments as having several connections to monetary and credit policy which led to reluctance to cede authority in this area to supra-national institutions and rules; key features of disparate national legal traditions had to be reconciled in a single regulatory framework; as was acknowledged in the Treaty of Rome itself, a single market for several categories of financial service required substantial liberalization of capital movements, and such liberalization itself took considerable time; and a crucial but in the event difficult choice had to be made as to the degree of harmonization of the rules under which financial firms would operate throughout the EU.

Divergences between the banking systems of EU countries are smaller than between those of the much larger number of countries which participated in the WTO negotiations. None the less the difficulties posed by the establishment of the EU regime bring out the way in which the opening of financial markets to non-resident firms and to cross-border transactions involves not only issues of microeconomic efficiency but also problems caused by broader qualitative changes in the institutional framework for supplying financial services and in the range of such services available.

Concern about the possibility of such qualitative changes appears to have been an important factor in the WTO negotiations, tempering willingness of countries to open their financial markets to increased international competition despite the benefits in terms of microeconomic efficiency which such opening may bring.  

No instance of deregulation or liberalization is quite like any other. But the experiences of OECD countries are cautionary as to the feasibility and desirability of very rapid liberalization.  

Liberalization can be a source of increased profits for financial firms and of benefits for users of financial services.  

However, as many recent studies have emphasised, it is also the source of new banking risks associated with the greater flexibility of asset prices, the expanded range of sources of funds and of permissible activities, increased competition amongst financial firms, and the resulting demands on these firms' systems of internal control and on the framework of financial regulation and supervision. 

The greater flexibility of interest rates and asset prices associated with liberalization exposes commercial banks to increased interest-rate and liquidity risks.  

Interest-rate risk is the result of banks' exposure (through mismatches in their assets and liabilities) to unexpected changes in interest rates, and liquidity risk of exposure to the inability to meet obligations as they become due -- through the sale of assets without incurring losses and acquisition of additional funding at a rate of interest not incorporating an increased risk premium.  

Liquidity risk is likely to increase as a result of liberalization for two reasons: in the new environment banks are less able to depend on stores of deposits with a low sensitivity to changes in interest rates and thus have to compete in financial markets to meet a larger share of their funding needs; at the same time the greater volatility of asset prices affects their ability to sell assets at par.  

Liberalization is also likely to expose banks to increased credit risk. This is partly because of the unfavourable effects of more volatile financial markets on the creditworthiness of many borrowers.  

But many financial firms will also be pushed by the pressures of greater competition into engaging in more risky lending and other activities. Another result of such pressures is increased technological risk which reflects commercial banks' exposure to their consequences for their costs and revenues of decisions regarding the choice of technology - a risk to which banks are increasingly prone owing to their reliance on electronics, automation and telecommunications.

Financial liberalization may also be accompanied by removal of barriers between commercial and investment banking and by a relaxation of exchange control affording the possibility of more extensive participation in international borrowing and lending. Involvement in the securities business exposes a bank to greater market risk due to fluctuations in the value of its "trading book" or portfolio of tradable assets. Increased participation in international borrowing and lending is a potential source of new kinds of mismatch between banks' assets and liabilities, for example, resulting from their recourse to borrowing in international markets for on-lending to domestic firms.  

Liberalization is also a source of risks and opportunities for financial firms other than commercial banks. The position of finance companies is similar to that of commercial banks, although in their case less diversified portfolios of assets and greater dependence on interest-rate sensitive and foreign-currency-denominated funding may expose them to still greater risks under liberalization. 

For securities firms and asset management companies the sequel to liberalization is likely include greater market risks due to more volatile asset prices, expansion into new activities, and other effects of increased competition.

The increased banking risks associated with financial liberalization can to varying degrees be reduced or offset through hedging and other techniques of risk management.

However, the instruments and banking skills required are less available in the great majority of developing countries.

Susceptibility to systemic banking risk is also generally greater in developing and transition economies.  

Problems due to banking risks and their interactions are more likely to pose systemic threats in countries where financial firms and regimes are characterised by weaknesses regarding internal controls and financial reporting, and by ineffective regulation and supervision.  

Systemic crises result not only from processes originating in the banking or securities sectors themselves but also from macroeconomic instability and shocks which are more likely to trigger such crises, the more prevalent are the weaknesses just mentioned. Systemic risk is thus enhanced in developing and transition economies in comparison with major OECD countries to the extent that the generally weaker banking systems of the fortner are exposed to greater frequency of macroeconomic shocks and instability." 

How does increased commercial presence for financial firms fit into this picture? One effect is likely to be increased competition. Such increased commercial presence may also be associated with macroeconomic developments requiring policy responses by governments.  

The potential benefits of greater competition are well rehearsed in the literature.

The dangers, on the other hand, are associated primarily with the additional competitive pressures which may result from too great an influx of foreign financial firms.  

These pressures operate in the same direction as others due to financial liberalization more generally (which were described above), for example, pushing domestic financial firms into new and higher-risk lending and other activities before the requisite skills and internal controls are in place. 

The presence of foreign financial firms may also have drastic effects on the balance of supply and demand in the market for people with banking skills -- to the detriment of both domestic firms and a country's system of financial regulation and supervision.  

On the macroeconomic front the increased presence of foreign financial firms (like the more general financial liberalization which usually accompanies it) is likely to lead to increased capital inflows and outflows, whose beneficial effects have to be reckoned against the problems which they are capable of posing to macroeconomic management.

The contribution of foreign financial firms to such capital movements is due to their typically greater involvement than domestic firms in international transactions: foreign commercial banks, for example, are more dependent on international borrowing and lending than their domestic counterparts; and the rationale for the commercial presence in a country of foreign securities firms and asset management companies generally includes their greater ability to attract foreign portfolio investment in assets traded in its financial markets and to facilitate or manage investment abroad by its residents.  

These are not arguments against the benefits of either financial liberalization or an expanded presence of foreign financial firms per se. But they do point to the disadvantages of excessive haste under either heading.

Moreover they suggest that the pace of developing countries' opening-up of their markets should be geared to a conservative timetable determined by the exigencies of the periods required for the implementation of effective regulation and supervision and the putting in place of effective internal controls by financial firms as well their acquisition of enhanced banking skills.

(* Based on a paper presented by the authors at a seminar in Vienna. Cornford is Economic Adviser, UNCTAD's Division on Globalization and Development Strategies. Jim Brandon is consultant to the division)