Financial institutions need regulation that keeps up with change

AuthorJorge Chan-Lau/Mark Swinburne
PositionIMF Monetary and Capital Markets Department
Pages134

Page 134

The expansion of financial institutions across borders has accelerated significantly in the past decade in both banking and other areas of finance. But regulation and supervision have not always kept pace. In banking, where there are more data to examine, the globalization of institutions has brought benefits to financial stability but may have changed the nature of the remaining risks. For individual financial institutions, geographic diversification has meant less volatile income and asset values, reduced exposure to domestic markets, and improved access to foreign markets. There are also broader financial sector development and efficiency benefits for many countries-especially emerging markets, which have benefited from knowledge and technology transfer. An open question, however, is what would happen to global and national financial stability if severe adverse events occurred, given banks' increased cross-border expansion.

The April 2007 Global Financial Stability Report examined the potential risks and implications for regulators.

Although global banking systems have weathered a number of shocks in recent years, they have, fortunately, not been tested by more extreme shocks that threaten to spill across borders, institutions, and markets. A relatively small number of large institutions are playing a leading role in local and international financial markets, which could increase the spillover effect of any large shocks.

This is not only a global issue involving the largest institutions; it is also an important regional and national issue and one that touches even smaller banks that operate internationally. Some indicators suggest that increased institutional globalization could hasten ripple effects across borders, reflecting either increased exposure to common shocks or institutional spillovers from ownership, trading, or other linkages. For example, implied market expectations of loss rates are higher for internationally diversified large banks as a group than they are for all large banks, including less diversified banks, as a group. Unlike measures that look at financial institutions individually, those that look at groups of banks allow for correlations between the institutions' expected losses.

Strengthening supervision

The nub of the issue for policymakers is the mismatch between the scope of institutions' activities, and the legal, regulatory, and supervisory frameworks. This...

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