Saturday, July 30, 2011

Regulators can't be complacent, especially now

Former Fed chairman Alan Greenspan recommends that "regulators must risk more to spur growth" (FT 26 July 2011)Still calling for loose regulation, Greenspan does not appear to have changed his minds after all....

Weighing growh and financial stability risk trade-off
In emerging economies, financial sector deepening through deregulations is an important growth strategy. Greater financial intermediation is expected to improve economic allocations and enhance central banks’ monetary policy transmission mechanism, among others. 
Nonetheless, financial deepening causes economic growth as long as the relationship is not exploited (Rousseau and Wachtel, 2007). Too rapid credit growth would actually weaken banking system.

In Indonesia, the main cheerleader for the currently above average credit growth is the central bank itself through its loan-to-deposit (LDR) regulation, where banks with LDRs falling outside a targeted range face higher reserve requirements. As noted elsewhere in the blog, such jawboning would easily tempt banks to relax their underwriting standards or saddle (smaller) banks with liquidity constraints.

Having been exposed to several headline economic and banking crises, I support the premise that closer regulation and supervision of banks will do more good than harm. A loose or exceedingly pro-growth financial sector policy tends to inspire perverse behavior. The consequences of greed on judgment of bankers, informational asymmetries and the asymmetry between private gains and socialized losses are among many good reasons for a close regulatory supervision of banking and finance.

Indicative of pervading complacency in Indonesia is the sector's refusal to adopt the Financial Stability Board (FSB) recommendation on sound compensation practices. Both the banking sector and the regulator underplay its relevance arguing that compensation level hinges on market conditions and should be up to shareholders to decide.
That is exactly the misplaced view that had prevailed before the 2008 crisis. While the concerns about the cost of salaries to the banks are for shareholders to sort out, the bonuses tend to reward short term payback and do not sufficiently penalize long run losses. It is squarely the business of the regulator when there are concerns that bankers have incentive schemes that lead to unnecessary risk taking with the public money. It seems for now Indonesia's regulator passes the opportunity to promptly benefit from the global momentum of reform in this area.
To give idea of executives' compensation level and bonus structure in these days, hereFSB is currently finalizing its second peer review on remuneration practices in the G24 group as reported here.

Need for narrowing the regulatory gap
Strong profitability of Indonesia's banks and confidence gained out of the success to escape from the financial crisis might account for the delayed adoption rate of the global regulatory initiatives including Basel II.  This is not unique to Indonesia since delayed implementations are more of the rule than the exception in the case of developing countries. With the introduction of Basel III - with Europe leading the pack based on the recent opening for the CRD IV consultation - the regulatory gap is set to widen even more.
For a survey of the regulatory gap between developed and developing economies, see Young Cho (2010) paper published in the ICFR website. For a summary of CRD IV by Cicero-Group, here.

Different pace of adoptions will create an unlevel playing field but could also form a regulatory arbitrage risk that may destabilize regional or global financial systems. One might argue that emerging economies’ financial sector is relatively small and domestically oriented, mitigating the risk concern. Again, the point is that financial sector is different from other sectors. Due to the ease with which losses can spread through the financial system in increasingly interlocking economies, regulatory developments should be subject to certain standardization and harmonization.

Vigilance called for (especially now)
Contrary to Mr. Greenspan’s emphasis on the primacy of unfettered markets and self-regulation in the financial sector, tight banking regulation and supervision must be sustained instead.

Indonesia's banking sector is presently having a good time, evidenced by high profitability, very easy financing conditions and bullish stock valuation - probably among the highest in the G20 countries! 
Under Basel III, regulators can solicit to operate the countercyclical buffer to discourage credit excesses at this point of economic cycle. Without Basel III, Bank Indonesia (BI) could fall back to other prudential measures on the menu (e.g. lower loan-to-value ratio, higher reserve requirement, remuneration policy).

Above all, BI should be prepared to ‘take away the punch bowl just as the party gets going’ (William McChesney Martin about the art of central banking).