asia regulation

With the West’s financial collapse in 2008, Asia’s banking systems are in search of a new regulatory model. They are keen that their financial sectors should not dominate the real economy.  

Asked how much India and its emerging market neighbours should be guided by Western financial models and conventions, Aditya Puri – who as managing director of HDFC heads one of the country’s biggest banking groups – does not take long to think. “That’s a simple one,” he laughs. “Not at all.”

It may be blunt, but it is an opinion that today is neither rare, nor especially controversial. It is, however, symptomatic of just how much prevailing wisdom has changed in recent years.

Not so long ago, many in the US and Europe would not even have thought it worth questioning the assumption that the majority of Asian countries should strive to replicate the sophisticated financial systems seen in the West. After all, sweeping deregulation on both sides of the Atlantic had turned Wall Street and London’s City into complex economic engines powering explosive growth in their respective countries.

This philosophy was dented by the Asian crisis of 1998, which exposed the dangers of ‘fast-track capitalism’. Broadly, though, the end goals remained unchanged, even if they were pursued at a more measured pace.

Recent years have, of course, dramatically eroded any notion of systemic superiority, and lent credence to economic powerhouses with rather different financial arrangements; notably India and China, which weathered global economic turmoil considerably better than their counterparts in the developed world. As a result, a growing contingent of emerging market bankers and policy-makers are becoming more vocal in their opposition of what were once accepted norms.

Islamic inspiration

If, as Mr Puri asserts, the West is no longer an economic model for the East to aspire to, where might emerging markets in search of a target model cast their eyes? Will legions of mini-Chinas crop up? Could India’s conservative, state-dominated financial system be a source of fiscal inspiration? Or might influence come from an even more unconventional source?

Since the collapse of the Soviet Union, the most radical alternative being implemented in any kind of scale has drawn on religious, rather than economic theory, but that has not stopped proponents of Islamic finance advocating its use as a safer alternative to the system that precipitated 2008’s meltdown and Europe’s current debt-induced woes. The theory is that because pure money speculation and interest-based returns are prohibited under sharia law, a cleric-endorsed system should result in a less leveraged, more secure financial sector.

Islamic finance’s moral high ground is hardly unassailable. Raising funds via sukuk did not help a number of firms that were forced to restructure during the 2009 Dubai debt crisis

Islamic finance is certainly maturing swiftly as a sector, and has passed a number of milestones recently, including the launch of a Libor alternative in the shape of the Islamic interbank benchmark rate – the first of its kind. It is also experiencing impressive growth; a recent Deutsche Bank report forecast that Islamic finance would almost double in size by 2016, reaching $1800bn in assets.

It could also prove useful in Asian development, according to ratings agency Standard & Poor's (S&P), which recently suggested Islamic finance would be a good match for financing the continent's infrastructure funding gap. The appeal is obvious, says an S&P credit analyst: “Its [growing popularity] is quite natural, because markets are on the lookout to find alternatives which would help participants go back to better days [and] they are looking at Islamic finance and thinking it could be a safe haven.”

Little impact

The analyst adds, however, that Islamic finance does not have the scale to be a genuine substitute at present. It currently accounts for about 1% of total assets in the global financial system, while the sukuk market makes up a similarly small proportion of global bond issuance. Even after doubling in size, it will still have a negligible impact on broader banking operations.

The nature of current growth is also questionable. A flight from conventional finance is inevitable in the current climate, but could well reverse once markets stabilise and jittery investors are reassured. Moreover, Islamic finance’s moral high ground is hardly unassailable. Raising funds via sukuk did not help a number of firms that were forced to restructure during the 2009 Dubai debt crisis. Similarly, curbs on speculation failed to safeguard Dubai Bank, which was taken over by Emirates NBD in October due to serious debt issues.

Modelling an entire economic ethos around Islamic finance then might be a little premature, especially as a fully standardised framework is yet to be established, due, in part, to theological disagreement. “There are still some difficulties with sharia interpretations,” says the S&P analyst. “Islamic finance is a very nascent industry, it's still searching its soul in terms of how it should regulate itself on a global basis.”

The Asian powerhouses

Less foreign to Western sensibilities are the financial sectors of Asia’s two potential superpowers, China and India, which have some similarities to US and European customs. Despite utterly different origins and strengths, however, both are also governed via high levels of state control and exercise heavy restrictions on foreign banking operations.

There may be some tendency in that direction [greater state control], but... I don’t think there’s any strong belief that a return to older models of financial organisation, such as a heavy reliance on state-owned banks is desirable... By and large, institutions, markets and regulation have developed and we have moved beyond that

Karl Habermeier

Whether or not either provides a model for imitation is open to debate. China, for example, while currently faring rather better than most of the West, may develop problems of its own in time. A recent report from the International Monetary Fund (IMF) found that its financial system faces “a steady build-up in vulnerabilities” stemming from excessive government control.  In any case, says Costas Stephanou, a member of the Financial Stability Board (FSB) secretariat, there appears to be little desire to follow in the footsteps of Asia’s dragon. “I haven’t seen anyone try to copy it, and I don’t think people aspire to China’s banking model.”

Heavy state influence in the Indian financial sector could make it an unlikely target for copycats, too, says Edwin Truman, a senior fellow with the Peterson Institute for International Economics and former assistant secretary and counsellor to the secretary of the US Treasury for International Affairs. “India is state dominated and heavily regulated… And it is usually two steps forward and one step back in terms of modernisation. I don’t see that being a model to emulate.”

And, says Karl Habermeier, division chief of the IMF’s monetary and capital markets department, there appears to be little desire to do so. “There may be some tendency in that direction [greater state control], but in most of the countries we observe, I don’t think there’s any strong belief that a return to older models of financial organisation, such as a heavy reliance on state-owned banks is desirable... By and large, institutions, markets and regulation have developed and we have moved beyond that, so I don’t think anyone can seriously suggest going back to the costs and inefficiencies associated with that kind of model.” 

Dubai trading

Same but different

By contrast, HDFC’s Mr Puri says he expects the influence of India’s financial system to extend even to Western economies. These views, as diametrically opposed as they initially seem, are not quite so incompatible, however. Mr Truman’s objection to India’s as a desirable financial system, stems chiefly from its state-run nature. But even Mr Puri does not forecast an increase in governmental control in India, or elsewhere, conceding that its influence over the Indian banking system must be reduced over time.

Instead, Mr Puri’s perception of the Indian model is of a financial sector that exists to serve the real economy, rather than miring itself in excessive complexity in an attempt to become itself a source of growth. “In India, it is very simple; we’re doing the same old banking. We are in the business of collecting deposits, lending in a secure manner, managing a good portfolio, running payment systems, dealing in foreign exchange, and in helping trade by assessing credit. And that’s all.” He allows for the inclusion of simple derivatives for hedging purposes and perhaps even some variety of securitisation, but there, he says, things should stop. “I think that’s quite enough. Yes some countries may need a debt market, or something else, but we don’t need the complications of the West.”

For regions with the potential for manufacturing or export-based growth in search of direction, the concept of financial sector as servant rather than unpredictable master would understandably appeal. It is also a theory that is echoed in a conversation with Andrew Sheng, chief advisor to the China banking regulatory commission and president of recently launched Hong Kong-based think tank Fung Global Institute. “The Asian financial system still follows the old model that finance is supposed to serve the real economy,” he says.

Mr Sheng is less keen, however, to position this approach as opposed in any sense to existing norms. “The Western system is not wholly wrong, I think they overshot in certain areas by being too complicated and too leveraged,” he says. In this respect, he adds, balance is key. “It’s only a matter of making sure that the relationship between the banking architecture and behaviour and the regulatory rules and its enforcement is, to use an Asian term, a golden mean.” 

That, certainly, is not a concept that will seem alien to Western bankers and regulators, and it is, in fact, one that chimes with UK Financial Services Authority chairman Adair Turner’s thesis of keeping the financial sector in a "socially optimal" position.

There are clear differences then, but perhaps not the unbridgeable ideological divide that may initially have loomed. Indeed, the FSB’s Mr Stephanou suggests that any concept of Eastern versus Western, or emerging versus developed models is rather premature. “Emerging markets don’t have to take what the developed countries are doing hook, line and sinker, and while I would love to have found one, I’m not sure there is a third way,” he says, adding that most of the broader differences are based on degrees of sophistication. “Most notably, depending on the country there are different views on propriatary trading and derivatives and the like, but I don’t see that the emerging model is very different from the US, for example.”

At odds

Degrees of sophistication can be huge in and of themselves, however, so how far will emerging markets look to develop? The steady process of financial sector development and capital account liberalisation recommended by the IMF has continued for some time, via guidelines on the sequence in which types of products should be introduced, but whether there is mass desire to progress past India’s basic derivatives plans, for example, is less clear.

rbi

“They [emerging markets] are lagging very much behind in terms of financial innovation and development of their financial sector,” says Domenico Lombardi, a senior fellow with The Brookings Institute and former executive board member with both the World Bank Group and IMF. “The fact that they have not been hit by the subprime crisis is reflected by the fact that their stage of development is much further behind.” This is unlikely to have been lost on emerging markets themselves, who having seen what Western levels of development and complexity have reaped, might find its desirability seriously tarnished.

Certainly, whether it is a disinclination to introduce complex derivatives, permit proprietary trading or legislate to allow high-frequency and algorithmic activity on the national bourse, there are likely to be major variations between East and West, as well as among Asian markets themselves.

Financial systems will always be sui generis to a greater or lesser extent, but drastic differences are certainly a worry, says Mr Stephanou. “Whether there will be more fragmentation is unclear, but what we want to avoid is exactly that. Markets are global and we want to ensure there’s adequate information sharing among national authorities… I think it will be a much more inefficient system globally if everyone goes their own ways.” However, he admits that in this case absolutes are few and far between. “These are all kinds of issues where we can’t a priori decide what is right or wrong.”

Some parting of ways seems likely. Almost universal agreement exists on the need for certain minimum regulatory standards and some level of global co-operation, but with no common consensus on the finer points, it is almost inevitable that Asia’s continued rise will lead to less, rather than more, homogeneity in rules, regulation and style.

By that same token, though, there can be a degree of certainty that because emerging markets are now important stakeholders in the world economy, the global approach to a regulatory framework, once chiefly in the hands of Western nations, will be far more influenced by systemically important emerging markets. It is a development that is already apparent in, for example, the founding of the FSB itself, which replaced the Financial Stability Forum, expanding its decision-making body from the G7 countries to the G20 in the process. Policy-making will no longer be conducted by an elite few without consulting the rest of the world.

And while a mass conversion to Islamic finance, or slavish imitation of China’s take on state capitalism, is unlikely, influence will now move both ways. Stark differences will remain for the foreseeable future, of course, but further co-operation, and by the same token, convergence, is a virtual inevitability. Perhaps meeting in the middle is not so unlikely after all.

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