Building Integrated Financial Markets 10 years after the Asian Crisis

(Chapter 4 of ADB Flagship Study)

Jenny CorbettAJRCANU

This is a draft and not for quotation. 29 October 2007

Chapter 4Building Integrated Financial Markets 10 years after the Asian CrisisJenny Corbett

I Introduction

10 years after the financial crisis of 1997 there is still some debate about the

proximate and more fundamental causes of the crisis. There is broad consensus that

at the time of the crisis, Asian financial systems were not equipped to handle the

capital flows generated by rapidly changing global markets, giving rise to the “double

mismatch” problem. There is much less consensus on which specific aspects of

their financial systems were crucial to the multiple failures.

Most economies have subsequently strengthened financial supervision and

disclosure; consolidated and recapitalized financial firms; improved reserves and

asset quality; and restructured non-financial firms with an eye to governance

(including privatization). As a result, the region has seen considerable financial

deepening and improvements in financial sector performance. The contagion of the

1990s, however, demonstrated that the quality of every financial system in the region

is of overall regional concern so it is relevant to look at the range of experience

across the region, not just at average performance. Some assessments of the

progress in quality of the financial sectors are still gloomy but broadly there is

evidence of considerable improvement.

Today most Asian countries have made partial progress to more diversified financial

systems but have not yet developed a full range of assets and markets of sufficient

quality nor the institutions and skills to intermediate their large savings and

investment flows. Reforms need to continue, along with initiatives to deepen and

connect capital markets and these policies need to be coordinated with

macroeconomic policies on the capital account.

The initiatives required to accelerate financial development, and financial integration,

are largely national, but regional cooperation can offer support, for example, by

defining standards for supervision, disclosure and regulation, by helping to create

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settlement mechanisms, and by supporting development of a range of markets. Such

measures should reduce financial vulnerabilities region-wide and also improve

access to resources for investments in infrastructure, business capacity, social needs

and consumer durables. These are key steps toward achieving the long-term vision

of a more closely integrated Asian capital market though they cannot guarantee

stability if the global financial markets are harbouring systemic problems.

This paper is designed to consider the current situation of financial integration in the

East Asian region against the background of changes in financial systems since the

crisis of 1997. Since the main indicators of integration reflect the extent of cross

border financial flows (or the price convergence that would indicate the potential for

arbitrage even if physical flows don't take place) the natural first focus is on border

barriers and capital controls. There are, however, several deeper elements that also

need consideration. To begin with, the questions of national treatment and market

entry behind the border have an obvious impact on the activity of foreign service

providers. Even deeper, and more difficult to assess, is the role played by different

levels of development in the markets in the region, by variation in the quality,

reliability and transparency of markets and the impact of differing regulatory systems.

Despite a plethora of studies on financial integration in the region there is no clear

view of how important these elements are, nor which among them rank most highly

as barriers to greater financial development and integration. It is therefore difficult to

give good policy advice and to identify priorities for regional cooperation. Many

things can be done, but current advice does not, and cannot, reflect empirically

established priorities and sequences. A more coordinated research effort to

establish these is an urgent priority

II Domestic improvements since the financial crisis

Most analyses of the financial crisis of 1997-8 attribute a large role to financial sector

weaknesses in both structure and governance. Furthermore, recent studies of the

extent of regional financial integration stress the limitations created by the levels of

development of domestic financial systems. There is certainly more development

needed but significant changes have already taken place.

There is a consensus emerging that the depth and coverage of financial markets, as

represented by aggregate data, has increased significantly over the last 10 years

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(Ghosh/World Bank 2006; Ghill and Kharas/World Bank 2006) but less consensus

on what further developments are needed and on the extent to which reforms have

adequately improved the quality of financial, governance and regulatory systems.

Starting with simple quantitative measures, Asian financial systems have grown and

deepened significantly since the crisis of 1997-98. World Bank data (Ghosh, 2006)

show that asset growth has been remarkable across the bank, equities and even

bond markets. By comparison with countries of similar income levels Asian markets

are of comparable or larger size (Table 1 and Figure 2) and on some measures (e.g.

equity market capitalisation in Hong Kong, Singapore and Malaysia ) surpass those

of developed countries.1

Table 1

Source: Gill and Kharas, 2006, p 174

4

Figure 1

Source, Ghosh 2006, p 4 and 27.

Note: The data for Thailand in this chart are not consistent with the data in the preceding

table which is also reproduced by Ghosh on the same page as the chart. Other country

data, excluding Thailand, do seem consistent.

It is frequently remarked that bond markets are still small in East Asia relative to

other types of finance and that the growth of bond markets has come mainly from

public bond issues (frequently to restructure ailing banking systems). The data,

however, suggest that the bond markets have been amongst the most rapidly

growing sectors of the financial systems in the region. Dhalla (2005) claims that

there are now three bond markets in East Asia (China, Korea and Malaysia) with

over US$100 billion and that the world’s two largest corporate bond markets relative

to GDP are in East Asia (Korea and Malaysia)

Beyond the bond and equity markets, It is not easy to get data on the size of markets

for the whole range of financial services that now exist in developed countries so it is

difficult to tell to what extent markets in Asia have expanded in sophistication and

range of services. One indicator is the size of assets of institutional investors in the

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different segments of the market as shown in Table 2 which indicates that the

markets in the region are still fairly small.

TABLE 2

Ghosh, p 130

Assessments of the improvement in the quality and efficiency of the financial systems

in the region are varied. Quantitative measures indicate significant improvement in

the levels of bad debts and corporate indebtedness (see Figures 3-4)

Figures 3

6

Source: Burton, Tseng and Kang, 2006.

Figure 4

Source: Burton, Tseng and Kang, 2006.

Efficiency indicators also suggest that the functions of financial markets have

improved. Efficiency of the banking sector has improved in terms of costs, NPLs,

return on assets and capital adequacy as indicated in Figures 5-6 (although data

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limitations and cross-country differences in accounting practices require caution

here) .

Figure 5

Source: IMF, Global Financial Stability report, Sept 2005, cited in Ghosh, 2006, p 68

Figure 6

Source: Ghosh, 2006, p 66

In the securities markets there is also evidence of improvement in function as well as

scale. Liquidity, transactions costs and informational quality are all important to the

functioning of securities markets. A World Bank index of market quality shown in

Figure 7 uses two indices, one of market liquidity and one of the information quality

of the market. The informational quality index captures three measures from the

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World Bank’s Doing Business Indicators i.e. disclosure, director liability and

shareholder suits. These three are taken to measure the strength of minority

shareholder protection. Combined with the liquidity measure these create a

composite index of market efficiency showing that most of the region’s markets are

well below average standards. Figure 7 shows some international comparisons.

Ultimately the information quality of the markets is demonstrated by lack of

synchronicity (i.e. the ability to distinguish individual movements of stocks within the

market). In explaining the outcomes on information quality Ghosh and Revilla find

that some institutional arrangements matter but many that might be expected to have

an effect do not appear important. Amongst their determinants disclosure rules are

very important but so are the availability of stock lending and short selling.

FIGURE 7 Stock market efficiency

A further important indicator of the functioning of financial systems is the

development of the insurance industry since it acts not only as an alternative savings

vehicle in many of these markets but also as a risk-sharing mechanism. The most

commonly used measures to assess the level of development of the sector are

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insurance penetration (measured as the insurance premium as a percentage of

GDP) and density (measured as the premium per capita). As Ghosh notes, “There is

still substantial scope for further development, particularly in China, Indonesia, the

Philippines, and Thailand (Table 6.6). Distribution channels are an important factor

in increasing the coverage of insurance. In most insurance markets in the region,

distribution has been built on the agency sales-force model, often extending to large

numbers of sales forces (with varying degrees of productivity, reflecting the extent to

which agents work full- or part-time).” (p 139). The alternative model for extending

insurance is for banks to market insurance products. This model, known as

bancassurance, developing rapidly in Europe, is also appearing in Asia. 2

Table 3

Source: Ghosh, p 139

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Despite these developments in the region over the 10 years since the crisis it is still

common to find assessments that vary on the details of how much more needs to be

done and how transparent, efficient and robust the region’s financial markets are

now. 3

Most assessments show modest improvements in corporate governance measures

(e.g. Cowen et al, 2006, p 20, based on Asian Corporate Governance Association

survey data) but several countries in the region are performing worse on measures of

the general governance climate or of corruption and law and order (Kramer, 2006

and Poonpatpibul, 2006 p 41). Bank governance appears still to be an area that

needs improvement in many of the region’s economies.

Data from the IMF Reports on Observance of Standards and Codes provide an

important addition to these qualitative data. Developing Asia (Bangladesh, India,

Indonesia, the Philippines, Sri Lanka and Thailand) exhibits lower compliance with

Basel Core Principles than the average for middle income countries. Most developing

Asian countries were non-compliant in principles regarding information sharing

between supervisors, ownership, prudential regulation and requirements, on-site and

off-site supervision, remedial measures, and cross-bordering banking. In addition, no

supervisor in the sample practiced consolidated supervision or incorporated country

risk control. On IAIS Principles (in insurance) the group outperformed peers. The

main weaknesses for insurance supervisors around the world lie in corporate

governance standards, internal controls and market conduct. In general, the

assessed Asian systems exhibit the same deficiencies as in other regions. In

applying IOSCO principles, securities regulators were not conducting proper market

surveillance and did not have adequate rules to detect and deter manipulation and

other unfair practices. In the implementation of standards of the committee on

Payment and Settlement Systesm (CPSS) developing Asia also lacks risk

management procedures, prompt final settlement, and arrangements for security,

reliability and governance ( Cowen et al, 2006, p 40). Figures 8 to 10 gives a

snapshot of this information from Financial Sector Assessment Program (FSAPs)

over the period 1999-2005.

Figure 8

11

Source: Cowen et al, 2006, p 39 Note: More detail is available in the same source on the specific components of each standard assessed.

One noticeable feature is that participation in both the FSAP and ROSC process is

low within the region. While there have certainly been criticisms of the procedures

and effectiveness of the IMF’s surveillance this is an obvious area for early decision

within regional fora. Either more countries in the region should take part in these

processes or regional alternatives should be created to provide similar monitoring.

Figure 9 and 10

12

Source: Cowen et al, 2006, p 43

Detailed survey data from Central Banks (shown in Table 4) also shows that

countries vary significantly in their compliance with best practice in detailed banking

supervision.

Table 4

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Indonesia Malaysia Philippines Singapore Thailand Risk-based supervision x x x x x Consolidated supervision x x x x More effective organization, risk-focus x x x Risk focus in allocation of staff resources x x x x x Specialized staff and supervisory units x x x x x Risk-focused, targeted on-site examinations x x x x x Strengthened off-site micro and macro monitoring x x x x x Early Warming Systems (EWS) x x x x x Improved databases x x x x x New examination manuals x x x x Major training efforts x x x x x Accreditation of bank examiners x Accreditation of banks’ credit and risk managers x Incremental enforcement actions x X Prompt Corrective Action (PCA) framework x X n/a Encourage mergers and consolidation x x X x x Mandate all banks to be externally rated x Mandate all banks to be listed X Deregulate pricing and fees x X n/a x Consumer protection and education x X x Corporate governance x x X x x Require board committees x x X x x Encourage outsourcing x X Encourage institutional investors x X Remove expatriate restrictions x Remove restrictions on salaries and mobility x External auditor accreditation and rotation x X x x Coordination with other dom. supervisors x x X n/a x Coordination with for. Supervisors x x X x x

14

Source: Lindgren, Carl-Johan (May 2006), Banking Integration in the ASEAN- Region: An Overview’, ADB Manila Philippines. Table based on questionnaires and central bank websites and annual reports.

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Similarities and differences of structure

Financial systems around the world differ in many respects and comparing them is

fraught with difficulty. Allen and Gale (2004) and Allen, Chui and Maddaloni, 2004, note

that comparisons should be made across many dimensions, recognising the many

functions of financial systems. Size of markets, measured by assets of particular

categories, is only one aspect. They also add the allocation of household and firms’

assets and liabilities by type, the size and number of institutions, the portfolio allocations

of institutional investors and aspects affecting the transmission of monetary policy, such

as the operation of mortgage markets and the formation of house prices. The practitioner

and policy community would add to this list disclosure systems, quality of regulation and

governance. Each of these comparisons is informative about different aspects of a

financial system and avoids the temptation to label systems simply as, for example,

“bank dominated” or “market oriented”. Quantitative measures and simple labels say

little about the efficiency and stability of financial systems which is, at the end of the day,

what we care about most.

Even on the simple quantitative dimensions, as noted above, while bond market

development has lagged by some measures, comparisons across a wider universe show

that variations in the size of bond markets are marked across developed markets as well

– the role and function of bonds appear to be a major source of difference in financial

markets across the globe. Corporate bond markets remain very small in the UK and

Japan as well as non-Japan Asia (see Allen, Chui and Maddaloni, 2004, figure 2). The

fact that bank assets still make up a relatively large share of many Asian countries

financial systems is also not unusual in global terms.

Ghosh notes

“Despite the progress made in diversifying financial markets, the banking sector remains

dominant, accounting for around 58 percent of the region’s total financial assets at the end of

2005 (down from 63 percent in 1997)” (p 27)

but also shows data that imply that Asian countries (with the exception of China) are

mostly not far from global averages in the ratio of bank assets to other assets when

adjusted for per capita income levels (see Figure 11)

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Figure 11

Source: Ghosh, 2006

It is not only comparison of financial systems that is difficult. Since many different

models of financial systems persist around the globe, there is no consensus in the

research literature that one system is better than another. Some systems appear to suit

particular industrial structures and systems for innovation better than others, but there is

no strong tendency towards convergence in type of financial system even amongst

advanced, industrialized economies. Freixas et al (2004) note that while differences are

frequently characterized as bank- versus market-oriented “… this distinction dos not

stand up to close scrutiny” . While continental Europe has large banking markets and

relatively small stock markets, it also has large bond markets. Japan not only has a

large banking market but also large bond and equity markets. The US is one “market-

oriented” system with large bond and equity markets but small banking markets but

there are few like it. Freixas et al go on to note that “A more significant difference is the

nature of financial institutions in different countries. Non-bank financial institutions, such

as pension funds and insurance companies play an even greater role in the Netherlands

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than they do in the UK but in the rest of continental Europe they are quite small. In the

US mutual funds are an important savings vehicle while in continental Europe equity

investments have frequently been channelled through banks so that equity markets and

the associated nbfis are relatively small”. They conclude “Overall, financial institutions

and markets have been organized on national lines and there has traditionally been little

cross-border flow in financial services”.

The key point is that there is still little evidence of convergence in financial market

structure or in the relative importance of different financial institutions towards any one

particular model. This is not to say that there is no adoption of some common practices.

Most countries have moved in the direction of global standards of disclosure and some

similarity in regulatory structures to protect investors. But there is an important

distinction between arguing for the advantages of adopting regulatory best practice and

confusing this with the need to move financial systems towards a standardized model.

The conclusion is that it is natural to expect a range of financial structures in the Asian

region to co-exist. Even with the greater adoption of standards of best practice in the

functioning of financial systems, the region will be home to a multitude of systems that

may be more or less “bank-centred”, with more or less active equity and bond markets.

The variation is evident in the data already presented. The shares of investment in

GDP and the contribution of investment to growth over the last 5 years has been erratic,

with falls much larger in Indonesia and Malaysia than in China and the faster growing

transition economies. Similarly, the development and change in financial markets is as

noticeable for the variance across the region as for the overall growth. Bank assets to

GDP ratios in 2005 ranged from 50% in Indonesia to 444% in Hong Kong; equity market

capitalization ranged from 18% in China to nearly 600% in Hong Kong while bond

markets ranged from close to 20% in Indonesia to 76% in Korea and 88% in Malaysia.

The range in the assets of institutional investors to GDP (pension funds, life insurance

funds and mutual funds ) was similarly wide. This variation may not only reflect

differences in levels of income and development but may also reflect the structural,

historical and local differences that were noted by Freixas et al across the globe. That

is, these differences may prove persistent, not merely transitory. If that is the case

policy attention should not be focused on trying to bring all economies in the region to

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the same level but on ensuring that systems are transparent and open enough to ensure

that all savers, borrowers and investors have access to the services they need to

smooth their consumption through time, to maximize returns to their investment and to

match the risk of their portfolios to their risk appetites.

Regulation

As noted above, despite the overall pattern of lower than expected financial integration

and of significant barriers to entry, there is a considerable degree of foreign penetration

in the region’s markets. As Table 5 shows, there have also been significant numbers of

cross-border banking investments in recent years and, where these groups continue to

operate in multiple markets, they pose some new regulatory and supervisory challenges.

This is true in a number of other financial service areas where the role of financial

conglomerates is large.

TABLE 5

Source: Ghosh, 2006, Appendix 1, p 182

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The challenge this poses is in the design of policies to adequately regulate the systems

and to ensure that they can interact and integrate smoothly. This requires a degree of

coordination and cooperation around the region that may grow exponentially if the

degree of financial integration increases.

III Regional Integration and Regional Interdependence (This section to be shortened and rewritten)

Global versus regional integration?

In recent years many studies of the causes of the financial crisis and of the changes

since those years have focused on the way the region’s financial systems link with other

financial systems. High profile studies have asked the question “How financially

integrated are countries in the region, both globally and among themselves?” (World

Bank, 2006) and many have reported (and repeated) claims that “Standard measures of

financial integration indicate that inter-regional integration continues to dominate intra-

regional integration” (Cowen et al, 2006). Others note that Asia is less regionally

integrated than Europe in terms of finance (Lee, 2007, Eichengree and Park, 2005). In

addition it is usually commented that trade integration has progressed further than

financial integration. On the face of it there is multi-faceted data to support these

observations althought they pose a fundamental question about what is meant by

financial integration and whether it is meaningful to describe systems as “more

integrated’ with some subset of the global financial system than another. If we take the

statements as meaningful the big questions that remain are what are the barriers holding

the region back, are there costs associated with the pattern and what policy initiatives

could help.

How integrated are Asia’s financial markets?

Measures of financial integration are broadly divided into 3 types: price measures,

quantity measures and regulatory or institutional measures.

Price measures

The price measures are based on assumptions that in fully “integrated”, or completely

open, markets, arbitrage would bring price equality on similar assets. In the case of

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cross-border transactions, involving different currencies, interest parity conditions are

used and there is a hierarchy of measures with increasingly stringent assumptions and

implications about the degree of integration. At the least stringent level, covered interest

parity would show a basic degree of financial integration (or at least, a failure of CIP

would suggest strongly that markets were not integrated) while at the top of the pyramid

(least likely to hold) real interest parity would indicate not only integrated markets but

also similarity of risk preferences. Some studies also look for price co-movements in

other asset classes such as stock markets but here the theoretical basis is less

compelling, since asset and risk characteristics may vary significantly. Even within

interest parity studies the details of methods vary considerably and the fundamental

question remains whether the assets being compared are truly identical as required by

theory.

What interest parity conditions mainly measure is the existence of some barrier to

investment flows i.e. a lack of openness of financial markets. This may be due to explicit

capital controls or to other barriers to foreign funds entry (or domestic funds exit) or it

might be due to a lack of information and awareness of external opportunities in small

countries that are “off the radar” of the international investment world. It might also be

because there are few truly identical financial instruments and, at the retail level at least,

the difference between a bank deposit in your home country and one abroad is likely

determined by your confidence in the level of protection afforded by regulations and the

ease of access to funds. Such factors may even influence assets such as wholesale

money market funds.

The broad picture from price based studies is that while regional interest differentials

have reduced on average there is variation between countries and across market

segments and the size of differentials is still significant.

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(Source: Kawai, presentation, “Europe Meets Asia: Regional Cooperation and

Integration: Ten Years after the Asian Financial CrisisTen Crisis” German Institute for

Economic Research (DIW) and ADB Berlin, 25 September 2007. Need more

information on how calculated, what countries included, covered/uncovered?,

real/nominal?, scale on axes)

Using correlation data there is evidence of some increased integration in price data for

equity markets but not much in the money markets and in bonds. Indeed some

observers conclude that integration in these areas has reduced since the crisis.

The evidence is rather varied. (NEEDS TO BE REWRITTEN WITH ORIGINAL DATA)

Cavoli et al (2004) survey several studies of price parities and they also recalculate the

uncovered interest parities between 8 East Asian economies (Table 6). They use simple

uncovered interest differentials from 6 month commercial CD rates, using the actual spot

rates 6 months out in place of expected exchange rate changes, and the authors note

that this constitutes a joint test of the covered interest parity condition and the currency

risk premium. Thus, data issues cannot be ignored (and there are no hypothesis or

significance tests offered) but these data do not appear to support a view that there has

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been a general increase in the degree of integration of money markets around the region

since the crisis. Some pairs of countries (Indonesia with Malaysia, Indonesia with Hong

Kong, Malaysia with Hong Kong, Philippines with Malaysia; Singapore with Philippines)

appear to have nearly fulfilled the UIP condition during the period 2000 to 2002 and to

have come closer to UIP after the crisis than before. On average Indonesia, Singapore,

Korea and China have smaller differentials after the crisis than before, though it is not

clear that the simple averages are very meaningful.

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Table 6Uncovered Interest Differential (in percent) January 1995-December 1996

Foreign Counties

Domestic Economy Malaysia Philippines Singapore Thailand Korea China Hong Kong Indonesia AverageIndonesia 2.98 2.53 4.83 1.98 5.26 1.02 3.84 - 3.21Thailand 1.01 0.54 2.85 - 3.27 -0.96 1.73 -1.98 0.92Malaysia - -0.45 1.85 -1.01 2.41 -1.96 0.66 -2.98 -0.21Philippines 0.45 - 2.28 -0.54 2.87 -1.51 1.44 -2.53 0.35Singapore -1.85 -2.28 - -2.85 0.54 -3.79 -2.57 -4.83 -2.33Korea -2.41 -2.87 -0.54 -3.27 - -4.37 -1.92 -5.26 -2.95China 1.96 1.51 3.79 0.96 4.37 - 2.68 -1.02 2.04Hong Kong -0.66 -1.44 1.23 -1.73 1.92 -2.68 - -3.84 -1.03

Source: Cavolli et al, 2004

Uncovered Interest Differential (in percent) January 2000-June 2002Foreign Counties

Domestic Economy Malaysia Philippines Singapore Thailand Korea China Hong Kong Indonesia AverageIndonesia 0.04 2.8 3.3 3.6 2.04 0.6 -0.03 - 1.76Thailand -3.38 -0.78 -0.56 - -1.76 -2.82 -3.44 -3.6 -2.33Malaysia - 2.8 2.44 3.38 1.37 0.56 -0.07 -0.04 1.49Philippines -2.8 - 0.02 0.78 -1.13 -2.24 -2.86 -2.8 -1.58Singapore -2.44 -0.02 - 0.56 -0.45 -1.94 -1.55 -3.3 -1.45Korea -1.37 1.13 0.45 1.76 - -1.31 -1.94 -2.04 -0.47China -0.56 2.24 1.94 2.82 1.31 - -0.63 -0.6 0.93Hong Kong 0.07 2.86 2.57 3.44 1.94 0.63 - 0.03 1.65

Source: Cavolli et al, 2004

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Poonpatpibul, Tanboon and Leelapornchai (2006) use the same “law of one price”

motivation to report the cross-country variation of overnight money market rates for 9

East Asian economies and note that while the dispersion fell markedly after 1999 the

standard deviation remains around 3% (Figure 12). They compare this with a figure for

European unsecured lending rates (Baele et al, 2004) of virtually zero after the

introduction of the Euro but since neither of these studies use covered or uncovered

interest differentials and therefore are not correcting for currency risks, comparisons

after the introduction of the Euro (with no currency risk) are not informative. Pre-Euro

deviations within Europe averaged around 2% between 1994 and 1998 so apparently

Asia post crisis is rather closer to Europe pre-Euro. Baele et al add a further test, which

would be useful for Asia if data were available, that compares the cross-country variation

with in-country variation (i.e across banks within country) to see whether the remaining

variation between countries is greater than the normal variation between banks. In

Europe both are nearly the same but no information is available for Asia. Without data

for the pre-crisis era in Asia it is also rather difficult to discern whether there has been an

increase in this measure of integration.

Figure 12

Source: Chaipat Poonpatpibul et al, 2006.

Takagi (2004) uses bilateral deviations from uncovered interest parity and bilateral

interest rate correlations to give a picture of which of ten Asian economies are closely

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linked to each other. The results are not directly comparable to other interest rate

measures but broadly indicate that a few countries stand out as much less integrated

with others in the region and a few country pairs are strongly linked. Japan and

Indonesia appear to have larger deviations from UIP over the period while Taiwan,

Singapore and Australia have smaller ones. A few obvious pairs seem closely linked:

Australia with New Zealand and Singapore with Hong Kong. The interest rate

correlation data does not give the same picture however, suggesting that Australia has

rather small correlations with others in the regions. Indonesia has small correlations with

most others in the region (though some country pairs are exceptions) while Thailand and

Singapore have high correlations. It is difficult to take away an overall sense of close

regional integration in interest rate measures from this data and it averages the whole

period, pre and post crisis, giving no information about trends. Ngiam (2002) is cited by

Takagi as reporting that deviations from covered interest parity widened in the region

after the crisis compared with before, though de Brouwer had noted a shrinking of

differentials between the 1980s and 1990s.

In addition to price convergence in money or banking markets, similar arguments have

been made for bond and equities markets, although it is much harder to find anything

like identical assets in these markets. In fact, many of the tests for co-movement or

convergence of prices do not appeal strictly to the law of one price as justification but to

an idea that, if markets are integrated, then the basic discount rates will converge which

will cause other rates of return to move together.

Ghosh (2006) shows local currency bond returns (of what type is not specified)

exhibiting very low correlations between Asian region markets (China, Indonesia, Korea,

Malaysia, Philippines, Thailand, Hong Kong, Singapore and Japan) in 2004 and

comparisons with developed country (UK, USA, Germany) correlations of 0.8 or larger

make the contrast striking.

Stock market correlations tend to show a more marked picture of co-movement of prices

and suggest some increase in integration after the crisis. Ghosh 2006 shows

correlations of equity returns pre and post crisis for 8 Asian economies and for the group

of East Asia together. For most economies the cross-correlations, and those with the

group, increase after the crisis, and they are higher than correlations for the region with

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the US or the EU. Tests for the importance of news as a determinant of equity returns

also suggests that news is more important after the crisis, implying more efficient

markets with less underlying volatility and markets that are more attune to developments

in the rest of the region and the rest of the world. With the exception of Korea, Thailand

and Hong Kong, however, the proportion of volatility explained by external news, even in

the post-crisis period, is still considerably lower than for the EU countries even before

the introduction of the Euro. There is at least general consistency with a number of

studies surveyed by Cavolli et al (2006) that stock markets in the region have become

more sensitive to external influences in the post crisis period although it is not easy to

read a regional effect in the results. Poonpatpibul et al (2006) give a similar picture

using only correlations, while Chai and Rhee (2005) give the same picture using both

correlations and variance decomposition, although the results of essentially the same

calculations as in Ghosh are of a completely different magnitude. They also find that

there is a large difference between the proportion of variance explained locally between

East Asia and Europe although they also show a reduction in local effects and an

increase in external ones in the recent period.

While no study does the comprehensive analysis across all the major financial markets

that Beale et al (2004) are able to do for Europe (covering money markets, corporate

bonds, government bonds, credit and equity), the pattern for Europe seems different

from the picture that has emerged for Asia. In Europe the money market is the most

integrated, government bond markets have become “significantly integrated” after the

introduction of the Euro while corporate bonds are “reasonably well integrated”. Equity

markets too have become more integrated while banking markets remain the least

integrated and display quite high price differentials, particularly in the consumer credit

sector. In the absence of detailed data for Asia all that can be said is that there is

evidence of some increased integration in price data for equity markets but not much in

the money markets and in bonds. Indeed some observers conclude that integration in

these areas has reduced since the crisis.

Quantity measures

Quantitative measures capture the extent of cross-border financial flows or the extent of

cross-border holdings of foreign assets and liabilities. These measures have no

particular theoretical foundation but do at least show the extent of actual flows (or

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stocks) of cross-border financial activity. The difficulties here are usually data. For

developing countries the accuracy and coverage of cross-border capital flow data is

particularly problematic, and for some asset classes almost non-existent. Nevertheless,

a number of studies have tried to discern patterns of cross-border activity and have

described these as reflecting the degree of integration of the markets. Ghosh (2006)

focuses simply on the proportions of assets held abroad in different regions and on the

sources of foreign-owned assets in the region. Both assets held abroad by the region

and the stock of foreign-owned assets inside the region grew, and this is offered as

evidence of increased integration with the world financial system. Ghosh notes also that

intra-regional holdings of both equities and bonds have increased and that the main

pattern is investment by the industrialising economies (Hong Kong, Korea and

Singapore) both into each others economies and into the developing economies (China,

Indonesia, Malaysia, the Philippines and Thailand) in both bonds and equities. The

developing East Asian economies have become considerable owners of equities in both

global markets and in the industrializing East Asian economies but do not have

significant bond holdings within the region. Ghosh takes these data to support the

conclusions of price data showing integration both globally and within East Asia in the

equities markets but less so in the bond markets. What is not evident is how this pattern

appears against any benchmarks. Are these holdings absolutely large or small and how

do they compare with either some theoretical norm or other regions’ behaviour?

At a minimum we need comparisons across countries and regions of the size of financial

holdings relative to GDP to give some normalization (Lane and Milesi-Ferretti, 2003,

Obstfeld and Rogoff). Asian economies hold, on average, assets valued at only about

half the European level relative to GDP (Lee (2007, using CIPS). Different data (IFS)

confirm broadly the same picture (Figure 13, Poonpatpibul et al, 2006) but there are

important caveats. Compared to the US, the average of Asian economies is quite

deeply integrated with the world financial system. The US has a much lower value of

foreign assets to GDP than either Asia or Europe. It can be misleading, however, to talk

of the degree of integration of the region as a whole, or on average. Within the Asian

region there is very large variation. Hong Kong and Singapore, as regional financial

centres, are much more integrated than the average European economy. Most of the

other countries of the region still hold very modest foreign assets in relation to their GDP.

28

Figure 13

Source: Poonpatipbul et al, BOT, 2006

The geographical distribution of asset holdings abroad and foreign holdings in the host

country give a more nuanced perspective on the Asian region’s engagement with

external financial systems compared with Europe and the US. This is not a theoretical

benchmark (which would make comparisons of countries’ holding relative to their share

of world financial endowments to judge deviation from the expected portfolio allocation in

a perfectly open world4) but it is a reasonable rule-of-thumb comparison.

On average, Lee shows that East Asian economies held about 4.9% of their foreign

portfolio assets within East Asia in 2003, while they owned 8.6% of the total foreign-held

assets in the region. These compared with 57% and 62% for Europe’s holdings in

Europe. (see Lee, Tables 1 and 2). Lee concludes, as do Poonpatpibul et al, that Asia

is much less integrated into the world’s financial system than Europe. In corss-border

bank flows Eichengreen and Park (2005) conclude the same.

29

Closer examination suggests something rather different. If Japan is excluded from the

East Asian group then 17% of assets held abroad are held in the East Asian region

compared with Europe’s 57%. In equities the proportion is 20% compared with Europe’s

53%, while in long term debt the comparison is 15% against 46% and in short term debt

18% against 59%. There is still, certainly, a large difference between Asia and Europe,

but excluding Japan increases the figures by several multiples. This reflects the fact

that Japan, a large, post-industrial economy is heavily invested in equivalent economies

elsewhere, rather than near neighbours. It also highlights the growth in Asia’s

integration in all directions since the first detailed data became available in 1997.

The pattern of ownership of the regions’ liabilities is also different from the conventional

view when Japan is excluded. Ownership shares jump from only 8.2% of all foreign held

liabilities in East Asia to 22%. These shares are still smaller than European ownership

of liabilities in Europe (at 61%) but by less of a margin. The pattern is consistent across

the different portfolio investment markets but remarkably, in short term debt, Asia’s

holdings of the regions’ liabilities (at 86% excluding Japan) is larger than Europe’s

holdings within Europe (at 86%). On these data, the markets in which the Asian region

is most “regionally integrated” in terms of its holdings of assets are first the equity

markets, then short term debt and finally long term debt (ranked excluding Japan) but

the international holdings of short term debt are much smaller than either of the other

two and are almost entirely accounted for by Hong Kong and Singapore. In terms of the

ownership of liabilities in the region, the order is reversed. The regional share is largest

in short term debt, next in long term debt and least in equities. The reason is that extra-

regional investors account for very large proportions of the inward portfolio investments

in equities.

30

Table 7

Ownership shares within the region

31

32

Small values of cross-border assets (or low shares to GDP) alone cannot necessarily be

taken to indicate low integration. The issue of benchmarks is crucial. By what standard

do we interpret these quantitative data? The gravity model is one approach to

determining whether intra-regional integration is lower than might be expected (cf Lee,

2007, Eichengreen & Park, 2005). Taking several characteristics of country pairs into

account this approach considers whether bilateral financial relations are lower or higher

than might be expected given the range of factors that generally explain bilateral cross-

border holdings of assets (size of the two economies, distance between the two,

common language, common borders and common colonial heritage). For portfolio

holdings Lee finds that the extra effect of being within the East Asian region is

significant. Country pairs within East Asia hold assets in each other that are 1.54 times

larger than would be held by a random pair of countries. Thus there is indeed evidence

of a degree of integration greater than “normal”. Furthermore, these data include Japan

in the East Asian group and, as already noted, this has the effect of depressing the

average proportion of assets held in the region. A similar exercise excluding Japan

should give an even larger regional integration factor. The number in these estimates

remains much smaller than the “Europe effect” which is on the order of 9 times the size

for a random pair. The behaviour of cross-border bank claims is rather different in very

simple gravity models (Eichengreen and Park, 2005) and suggests that the Asian

regional effect is even greater than the effect for Europe. Once bilateral trade flows are

accounted for, however, the Asian regional effects in both portfolio and bank claims

become negative. This means that larger bilateral trade flows have such a large positive

effect on financial flows that, once that effect is taken out, the additional effect of being

within the Asian region is negative – financial flows in both Asia and Europe are lower

than they would be between random pairs of countries with similar bilateral trade flows. 5

The conclusion from these studies is that there is evidence of above average financial

integration amongst Asian economies, even though it is still less than between European

economies, but that it may be largely explained by the degree of bilateral trade between

countries in the region. Once trade is accounted for there is less integration in the

region than normal and this pattern is replicated across most types of portfolio assets

(equities, long-term debt and bank claims; short term debt is not so affected).

Interestingly similar patterns are found in Europe – once trade is accounted for, the

positive regional effect either becomes negative (in bank claims), very small (short term

33

debt) or at least much smaller than before trade effects (equities and long term debt).

These are important indicators of what drives or impedes financial integration, to which

we will return.

Consumption correlations

Another important aspect of the quantitative integration of the regions’ financial markets

is shown by measures of correlations between consumption, savings and investments.

The rationale is that integrated financial markets allow global movements of savings and

investment. This should mean that investors in one country are not limited by access to

only domestic savings6. Fully open capital markets and fully integrated financial systems

should imply no correlation between domestic savings and investment for any individual

country. Furthermore, the desire to smooth consumption can be met by access to

capital markets either at home or abroad, so a related approach to measuring integration

is to look for convergence of consumption paths between countries. If countries are able

to smooth the path of their consumption this implies that they have access to capital

markets and are able to reduce or share the risks of consumption volatility. Under

perfect risk sharing the consumption growth rate of one country would equal that of the

world consumption growth.

There are relatively few careful attempts to analyse consumption risk sharing as an

indicator of the degree of integration for the Asian region and several are quite old.

Broadly the data suggest that there have always been quite high correlations between

domestic investment and savings, indicating low degrees of openness before and after

the crisis years (Montiel, 1994, Le, 2000, Isaksson, 2001). Performance for individual

countries across the region varied considerably. The diagrams from the Poonpatpibul et

al (Figure 13) give a pretty clear picture of what all variations of this analytical approach

will find - a high degree of co-movement of domestic consumption with domestic

production.

Figure 13

34

35

Source: Chaipat Poonpatpibul, Surach Tanboon and Pornnapa Leelapornchai, 2006, BOT . Notes: Figures in brackets refer to the growth rate between 1986 and 2004 of real consumption and real output respectively

In formal tests of whether individual countries in the Asian region share risks with other

regional economies or with the world (or not at all) Kim, Lee and Shin (2007) show that

the pattern of regional and global risk sharing for Asia and Europe are quite different.

Asian economies have a lower degree of risk sharing within the region but a higher

degree of risk sharing globally than Europe. Not all countries are achieving risk sharing.

Out of 10 Asian countries 4 had significant risk sharing with the region (China, Hong

Kong, South Korea and Taiwan) while four had significant global risk sharing (Japan,

Philippines, Singapore and Thailand). On average the Asian economies have lower

overall levels of risk sharing than Europe.

36

The authors propose a challenging explanation for these results. Under a capital asset

pricing model (CAPM) view of the world, investors should diversify their portfolios to the

greatest possible extent, choosing securities with low correlation with each other and

with the home portfolio. If this argument carries across to countries (and it is much more

complex to make this transition) then “countries with different structures, subject to

different economic shocks, with low business cycle correlation, will find it more

advantageous to develop closer financial links with one another. In this regard,

extensive portfolio diversification within East Asia may not be necessarily an optimal

strategy, considering the homogeneity of East Asian economies.” By homogeneity, the

authors mean close correlation of output growth rates within the region. This argument

seems to imply that “the welfare gains for regional financial integration are lower in East

Asia than in Europe” (Lee et al, 2007). This is not necessarily a wide-spread view and

other estimates have set the gains from consumption risk sharing very high in Asia.

As noted earlier, both quantity and price measures may be seen as measuring either

integration or openness of financial systems and while the two concepts are often used

interchangeably they are not quite the same. The integration measures capture the

after-the-fact extent of financial trades and price movements and indirectly reflect the

openness of systems to cross-border flows. Direct measures of the barriers to flows can

be an important part of the picture. The distinction here is between de facto measures

of openness (or the degree of integration) and de jure measures (that show whether

policies restrict access to financial markets or limit capital account transactions).

Direct measures of barriers

There are several different interpretations of just how open Asian financial markets are,

based on variations of the de jure measures. The measures most commonly capture

direct capital controls but a few indicate the extent of deeper liberalization in financial

sectors behind the border.

Most Asian economies had made quite modest commitments on financial services by the

end of the GATS round in 1997 (see Table in Appendix and Figures below). Since the

GATS requires only limited capital account opening and only in so far as capital flows

form an “essential part of the liberalized service” or are “related to the supply of the

37

service” (Kono and Schuknecht, 1998 and Parrenas, 2007). This picture does not

suggest that the financial sectors in Asia have been significantly opened as a result of

trade commitments7. Contreras and Yi (2004, cited by Parrena) concluded that East

Asian economies’ core banking, core insurance and securities services are closed or

partially closed to foreign competition while auxiliary financial services, financial data

processing and other insurance services are largely open. These conclusions, drawn

from study of the GATS commitments, do not sit well alongside evidence of the actual

involvement of foreign providers in financial services and indicate how difficult it is to

match policy statements with actual practice and outcome.

Figure 14

Source: Parrenas, 2007, p 24

Figure 15

38

Source: Parrenas, 2007, p 24

Other indicators of behind-the-border liberalization give a picture of greater opening.

The most frequently cited are the measures of Kaminsky and Schmukler (2003) that

show gradual progress in liberalisation of the domestic financial systems and stock

markets but much slower opening in capital markets in seven East Asian economies

(Figure 16, from Park and Bae, 2002).

Figure 16

39

Source: Cited in Park and Bae, (2002). Notes: To measure the liberalization of the domestic financial system, Kaminsky and Schmukler analyze the regulations on deposit interest rates, lending interest rates, allocation of credit, and foreign currency deposits. As additional information, they also collect data on reserve requirements. To set the liberalization dates, they focus mainly on the first two variables, the price indicators. However, they complement that information with the regulations on the last three variables, those on quantities, to have a better picture of the degree of repression of the domestic financial sector. Finally, to track the liberalization of stock markets, they study the evolution of regulations on the acquisition of shares in the domestic stock market by foreigners, repatriation of capital, and repatriation of interest and dividends. (Kaminsky and Schmukler,

2002, p 9)

40

Direct measures of capital account opening are also an important component of

understanding the pattern of Asia’s financial integration. These are likely to be a

necessary, but not sufficient, condition for greater integration. Without some such

measures it is difficult to assess the effect capital controls have on the degree of

integration and to consider whether they are part of a policy arsenal that could be

deployed to encourage further integration. The difficulty of capturing policy change by

measurable variables is well known. The choices for measurement of the extent of

capital account opening are fairly limited but there are a number of different approaches.

Essentially there are several variations on an index of “on-off” restrictions based on the

IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions and there

are (fewer) measures based on the actual accessibility of parts of the financial system.

The results of these studies do not give a consistent picture. Miniane (2004) concludes

that there has been minimal reduction in capital account restrictions in Asia, with the

exception of Korea, and that in many economies barriers rose after the financial crisis.

With more disaggregated data from the same underlying IMF source Park and Bae

(2002) conclude that there has been fairly steady reduction in capital account barriers in

most Asian economies with the exception of Malaysia which famously imposed tighter

controls in response to the crisis.

Using dummy variables, however disaggregated, gives no way to distinguish which of

the components drives the change in status of a particular country even though it is likely

that not all components matter equally. Chinn and Ito (2007) develop a variant of the

dummy variable measures of Miniane and others. They derive the principal component

of four variables that include both the conventional capital account controls and also

measures of the presence of multiple exchange rates, controls on current account

transactions and the need to surrender export proceeds. These are expressed in terms

of degrees of openness rather than whether restrictions exist, and data are available for

181 countries back to 1983. This measure has the advantage of incorporating a more

extensive range of restrictions that would impact on cross-border capital movements.

From Figure 9 it is clear that “the pace – and pattern – of financial opening exhibits wide

regional variation. The Asian region has had relatively high levels of financial openness

since the 1970s, although the rate of financial opening slowed down in the aftermath of

the Asian crisis of 1997-98” (p7).

41

Figure 17

Source: Chinn and Ito, 2007, p 17

Figure 18, using the most recent version of the Chinn-Ito data, shows the position for

individual economies in East Asian up to 2006. Individual variation within the region is

noticeable, with some countries decreasing openness after the crisis.

Figure 18

42

-2

-1

0

1

2

3

US

UK

AU

S

JP

N

PR

C

IND

HK

G

KO

R

SG

P

IDN

MY

S

PH

L

TH

A

VN

M

1986-1996 Average 1999-2005 Average

Source: Calculated from data available at http://www.ssc.wisc.edu/~mchinn/research.htmlNote: The apparent decline in openness for Australia is an artifact of the more detailed data that became available after 1996 when one component of the IMF data was provided at a more disaggregated level. This resulted in one variable that previously had been classified as no restriction becoming a restriction. In contrast to the previous figure the data are not normalized to have minimum values of zero.

Edison and Warnock combine some elements of both de facto and de jure

characteristics by measuring the proportion of an economy’s stock market that is

available to foreign investors. Taking one minus the ratio of the investable part of the

stock market to the total market capitalisation they create an index which captures not

only the legal restrictions, but also the intensity of them. A higher index shows that a

higher proportion of the stock market is not accessible to foreign investment – showing

not merely the existence of restrictions but how pervasive they are. The data for 10

Asian countries are shown below (Figure 19)

Figure 19 Edison-Warnock measure of restrictiveness of controls on stock markets

43

44

Source; H.J. Edison, F.E. Warnock, (2003)

These data show that restrictions in Asia were initially quite high and that, while they

declined over the 1990s, the timing extent and evolution varied in different economies.

The overall level of restriction remains quite high for most of the region. The patterns

are similar to those shown by other measures: Korea, Indonesia, Thailand, Taiwan have

become more open while Malaysia’s experiment with restrictions shows very clearly. The

Philippines shows very little change from its quite high pre-crisis level of restriction. It is

notable that India remains quite heavily restricted. However it is hard to take away from

these measures the conviction expressed by Takagi and Hirose (2004, p 133) that there

has been a reversal of the pre-crisis trend to great financial integration, reflecting a

change in attitude globally towards a greater acceptance of moderate capital controls. In

45

their view this attitude shift explains why “the capital account regime, at least in some

countries in East Asia, is not as open today as it was before the crisis” p 133 .

Considering the mixed picture presented by different measures of de facto and de jure

integration or openness, the appeal of some composite measure covering several

different indices seems clear. Surprisingly, composite (multivariate) indicators of

financial integration are a relatively recent development and few studies have applied

this approach to Asia. Takagi and Hirose (2004) is an exception that uses principal

components analysis of five dimensions of financial integration: exchange rate volatility,

deviations from purchasing power parity, deviations from uncovered interest parity, trade

intensity, and short term nominal interest rate correlation. They derive a single indicator

of integration between pairs of countries in the Asia region and then group countries by

cluster analysis to show which are more closely integrated and whether groups of closely

integrated countries can be identified. They conclude that there are two groups of

closely integrated economies: one group consists of Australia, New Zealand, Singapore

and Taiwan while the second group covers Malaysia, the Philippines and Thailand.

These groups are, however, significantly influenced by the heavy weight given to

exchange rate volatility in the principal components analysis and may not be very

informative. Their research was not designed to compare the degree of integration

within the region against any other, nor to show changes over time, although it could be

adapted to both purposes. More importantly, the choice of which underlying indicators of

integration to include is crucial and there would be many competing choices available

but the approach warrants further development.

What drives integration?

Although the extent of financial integration between the region and the rest of the world,

and within the region itself, may still be open to debate, and there is still some variation

in views about whether integration and openness have increased or decreased since the

crisis, a picture emerges of slow, and sometimes sporadic, increase in financial

integration. What can be said about the main drivers of the process? In particular, do

the remaining de jure barriers explain a low level of financial integration or are other

factors more important?

46

The literature here is extensive but mainly does not focus on this specific question, but a

few conclusions do emerge. Most research suggests that removing de jure capital

controls does not automatically result in increased integration although removing the

Edison Warnock type restrictions on access to domestic stock markets by foreign

investors does result in increased portfolio investment by foreigners. Adding capital

control variables to the gravity models does not suggest that financial flows would be

closer in the absence of the controls.

The major explanation of degrees of financial integration seems to be trade. Countries

with large trade flows will likely also have large capital flows relative to GDP. There is

debate about whether finance follows trade or the reverse but it does seem that this is

an important element of the difference between Asia and Europe. In so far as trade

integration has been a market-driven, bottom-up process in Asia, it is probable that the

same will be true of financial integration.

What is much less clear is how much is actually contributed by the policy and financial

structure variables that regularly turn up in lists of desirable reforms to promote greater

integration. Ghosh (2006) lists the impediments to greater cross-border transactions as

including withholding taxes, a lack of hedging instruments, differences in market

practices and infrastructure such as trading platforms and conventions, procedures for

clearance and settlement and custodian systems, differences in rating standards,

national legal and regulatory frameworks and accounting and auditing practices. To this

list others have added the “underdevelopment of financial markets”, inadequate financial

and legal structure, low auditing and accounting standards, low transparency, weak

corporate governance (Lee, 2007). Parrenas (2007) surveys several papers and picks

out recommendations to improve transparency, legal systems, insolvency systems and

workout procedures, competition and free entry, risk pricing undistorted by subsidies or

interest rate controls, clearing and settlement systems, government bond markets and

benchmark yields and the promotion of securitization.

We have only limited consistent statistical evidence on which of these desiderata

actually affect the extent of financial integration. Lane and Milesi-Ferretti (2007) find

that financial depth and the size of stock markets have an effect but, tellingly, corporate

income tax rates and the introduction of insider trading laws have no effect. Ostry et al

47

(IMF, 2007) suggest that domestic policies towards the financial system do have an

effect. Capital controls, institutional quality, trade openness and the level of economic

development affect the overall extent of openness (measured by total foreign liabilities

as a share of GDP). The institutional quality index is an average of indicators covering

voice and accountability, political stability and absence of violence, government

effectiveness, regulatory quality, rule of law and control of corruption. The measurement

of all of these is contentious and they are much bigger policy issues than simply

improving financial systems, difficult as that may be. Much of the policy advice and

discussion that follows here, and in other papers, is based on intuition and anecdotal

evidence about what would improve financial systems, rather than on hard evidence.

There is a clear need for more research on these issues.

Foreign influence in regional financial systems is growing

Despite the impression of a relatively slow-to-integrate region there has been a very

marked increase in the degree of foreign participation in the domestic systems of the

region and in some types of cross-border activity. As Park and Bae (2002) document

there has been a dramatic increase in foreign ownership of banks in most emerging

market economies during the second half of the 1990s. Foreign banks’ penetration was

traditionally low in East Asia because of barriers to entry but this has changed since the

1997-98 crisis (Table 3 from their Table 14, reproduced below). Foreign bank control

over assets of local banks jumped from less than one percent in Korea in 1994 to 4.3

percent in 1999. In Indonesia, it rose by more than ten times during the same period.

On average, the foreign control in Korea, Malaysia and Thailand rose to 6 percent in

1999 from 1.6 percent five years earlier. Similarly, as a result of the lending behaviour of

BIS reporting banks, foreign banks’ credit as a share of total bank credit more than

doubled in Malaysia: it rose to more than 40 percent after the 1997 crisis from an

average of less than 20 percent over the 1990-96 period. In the Philippines the share

jumped to 35.5 percent in 2001 after a sustained decline during the first half of the 1990s

and in Thailand there has been a gradual increase in foreign banks share. Foreign

banks also made a substantial gain in terms of the loan market share, which reached

almost the 30 percent level in Malaysia. Only in Taiwan and Korea, have foreign banks

have not been able to increase their loan market shares. Much of the increase in the

market share of foreign banks in the Southeast Asian countries has come from the large

increase in their local currency (see Park and Bae’s Figure 4).

48

Table 8

Source: Park and Bae, 2002

An important additional feature is that while foreign bank penetration in East Asia is still

lagging behind that in other emerging market economies, American and European banks

have established a near monopoly position in providing two major services in the capital

markets in East Asia: 1) underwriting in the primary market and 2) trading and

consulting in the secondary market. It is hard to quantify the value of financial services

and data are sparse so only data related to investment banking are presented to show

the dominance of American and European financial institutions in financial services in

East Asia. Western financial institutions, in particular American ones, have been by far

the largest providers of financial services in global investment banking. A Euromoney

1996 “poll of polls’ showed that of the top 20 investment banks (based on a compilation

of 70 Euromoney polls and league tables produced in 1995), almost all were either

American or European. Six years later, this dominance remained unchanged; only one

Japanese investment bank made the list (see Table 9).

Table 9

49

Source: Park and Bae, 2002

Euromoney poll results in other areas also confirm the dominance of American and

European institutions in providing the entire range of financial services (see Table 12 in

Park & Bae) . US-based financial institutions led in every category of services, followed

by British-based ones. No financial institution was based in Asia with the exception of

Japan, and even then, the Japanese institutions were ranked last. The Euromoney poll

in 2002 shows that American investment banks had increased their dominance further;

Japanese investment banks have been largely driven out of the market for capital

market services since 1995.

Table 10 and 11 classify the capital market instruments issued in the five Asian

countries during the 1991-2001 period by nationality of the lead managers or book

runners who sponsored the new issues. Out of US$ 31.96 billion that was financed

through capital markets for the 1998-2001 period by the six countries, 74 percent was

undertaken by American and European investment banks, and 6 percent by Japanese

institutions. The cumulative figures for the 1991-1997 period show almost 70 percent of

the capital market financing was managed by western institutions, compared to 30

percent by East Asian investment banks. Table 5 further shows a very significant

change in the structure of East Asia’s international financing. Before the 1997 crisis the

East Asian countries had relied heavily on syndicated loan financing. In the early 1990s,

50

the six East Asian countries secured more than 70 percent of their total international

financing from banking institutions. The proportion of loan financing declined gradually,

and after the 1997 crisis, all of their foreign financing has come from capital markets. In

managing the

syndication loan financing, East Asian banks maintained a share of the market during

the 1991-2001 period, reflecting the bank dominance of the East Asian financing

systems.

Table 10

51

Source: Park and Bae, 2002

Park and Bae further use the evidence in Table 11 to show that American and European

lead managers accounted for more than 70 percent of all capital market financing, while

Japanese institutions represented only 9 percent over 1991-2001. Table 7 lists the top

20 lead managers in the management of debt and equity issues. As they point out, the

total amount underwritten shows a similar pattern of dominance by American and

European institutions which represented 90 percent while the East Asian institutions only

accounted for 10 percent. They report that according to Risk Magazine (November

1996), most first-tier derivative brokers and dealers were either American or European

institutions when evaluated on pricing ability, market making reliability and liquidity,

innovation and speed of transaction, even before the 1997- 98 crisis. No Asian region

financial institution was ranked in the first tier as either active brokers or dealers of Asian

derivatives.

One important cause of the absence of regional players in these markets was the

financial crisis and the non-performing loan problems of Japanese banks which curtailed

their lending activities and caused them to withdraw from the region.

Table 11

52

Source: Park and Bae, 2002

Table 12

53

Source; Park and Bae, 2002

Table 13

54

Source: Park and Bae, 2002

A similar picture emerges from other indicators. Parrenas (2007) notes that

trends in foreign investment in East Asia’s financial services industries reflect the

growing openness of the region’s markets throughout the last decade, particularly with

respect to commercial presence. Figures 20-24 show the growth of foreign investment

in financial services in a number of East Asian economies. Despite the overall growth,

there are some variations in the importance of foreign investment (relative to domestic

investment) in the restructuring of financial systems (Figure 21). In about half of East

Asian economies (Thailand, Hong Kong, China, Indonesia and South Korea), foreign

investment played a substantial role in the restructuring of regional financial systems,

exceeding 50% of total investment in Thailand, Hong Kong and China. In the other half

(Japan, Malaysia, Singapore, the Philippines and Taiwan), financial restructuring was

55

largely achieved through domestically-funded mergers and acquisitions. Commercial

banking has been the sector most transformed by foreign investment (Figures 22-23) in

part as a result of acquisitions of non-performing loan portfolios). In a few economies,

however, investment in other financial services was significant. The insurance industry

in China and Taiwan, and the securities industry in Hong Kong, Malaysia and China are

example. There is also variety in the region in both the size and sector distribution of

foreign investment, as Figure 24 shows. These data indicate that, with the exception of

Thailand, foreign investment in East Asia’s financial services industry has come to play

more significant roles in the insurance and securities industries, as well as in other credit

institutions. Figure 24 confirms the points made by Park and Bae about the dominance

of foreign lead managers.

Figure 20

Source: Parrenas, 2007, p 26

Figure 21

56

Source: Parrnas, 2007, P 27

Figure 22

57

Source: Parrenas, 2007.

Figure23

Source: Parrenas, 2007, p

58

Figure 24

Source: Parrenas, 2007,

These indicators of penetration by foreign financial service providers are important not

only for what they say about the extent to which financial integration is taking place but

also for the challenge they pose in terms of regulation and supervision, to which we

return below.

IV Regional cooperation

There already exist a number of regional fora in which financial issues are considered.

Table 14 indicates the membership of the major government level groups and some

elements of their structure. In addition there are several industry-initiated bodies that

exchange information and may have a role in helping develop best practice and self-

regulatory expertise.

59

Several recent studies (Poonpatibul et al, 2006; Yap 2007; Boao Forum Annual Report,

2007; ASEAN Secretariat and Australian Treasury (Hew et al), 2007) Dobson, 2004

and 2006) describe well the range and functions of the various regional groups that have

some involvement with financial issues. As Table 14 shows, most countries in the

region belong to several different groupings and many have work programs covering

related (or substantially the same) areas. At present it is probably fair to say that there

are enough groups tasked with collecting and sharing information between their

members (although as noted in the conclusions there are still some kinds of information

that could usefully be added) but, though several of them are also intended to carry out

surveillance and peer review, the surveillance element is still weaker than desirable.

Furthermore, there is clearly considerable overlap in the focus of several different

groups. This may have desirable elements since some groups include members that

bring valuable perspectives to the task but who are excluded from other groups. It does

mean, however, that there can be considerable duplication of effort. It is also

unnecessarily difficult to discover the different work programs and initiatives within each

group relating to the same area. The compilations from which Table 14 are drawn are

found in research papers or deep within annual reports. Yet this, at-a-glance description

of the work being done on financial integration and market building is necessary every

time a working group considers what remains to be done. In addition it would be useful

to have similar information organised by topic or market segment so that it would be

easy to discover under the heading say of “liquidity support” or “capital market rules

harmonisation” which groups were working on what elements. Such a database would

not be very difficult to compile and could be kept up-to-date by agreement across the

various organisations. It could usefully reside at the ADB ARIC website.

Table 14

60

CENTRAL BANK COOPERATION FINANCE MINISTRY-LED COOPERATION

ACD EMEAP SEACEN SEANZA APEC ASEAN ASEAN+3 ASEMYear established 1991.2 1966.2 1956 1994.3 1967.8 1999.4 1997.9Members 28 11 16 20 21 10 13 39Indonesia,Malaysia, Philippines, Singapore, Thailand

X X X X X X X X

Brunei X X X X X XVietnam X X X X X XCambodia, Myanmar, Lao PDR

X X(all except Laos?)

X X X

Hong Kong, X X ? X XTaiwan X X X XKorea X X X X X X XChina, Japan X X X X X XAustralia, X X XNew Zealand X X XMongolia, Nepal, Sri Lanka

? X

Papua New Guinea ? X XBangladesh, Iran, Macau,

? X

India ? X X XFiji ? XCanada, Chile, Mexico, Russia, US

X

EU-25 X

TABLE 14 REGIONAL COOPERATION FORA

61

ACD EMEAP SEACEN SEANZA APEC ASEAN ASEAN+3 ASEM

StructureGovernors’ mtg 1x pa 1x pa biennialDeputies mtg 2x pa 1x pa 1x pa 1x pa 3x pa 1x paWorking level WGFM: 4x pa

WGBS, WGPS: 2x pa

On a need basis

On a need basis

One a need basis

Areas of WorkFinancial Market Development

X ABF 1 & 2(insert others)

X X AFMM ACBG (ACBF)

X AFMM+3 ABMI

X

Payment and Settlement

X BPA

Banking Supervision

X

Surveillance X X X X X ASCU X X- Economic Review X X X X- Policy Dialogue X X X X X XCapacity Building X X X X X X X- Training X X X X X XReseach X X X X X XLiquidity arrangements

X EMEAP Repo

X CMI

Initiatives (finance related)

Finance Ministers Process; Surveillance Process; ASEAN Swap

Finance Ministers Process; Economic Review and Policy

62

Arrangement;Roadmap for Financial and Monetary Integration; ACMF; Exchange Linkages Task Force;Asia 100 benchmark and index

Dialogue (ERPD); ASEAN+3 Research Group; CMI, ABMI

Source: Poonpatpibul et al, 2006; Yap, 2007; Baoa Forum Annual Report, 2007Notes: ACD = Asia Cooperation Dialogue; APEC=Association of Pacific Economic Cooperation; ASEAN=Association of Southeast Asian Nations; ASEM=Asia Europe Meeting; EMEAP=Executives’ Meeting of East Asia and Pacific Central Banks;SEACEN=South East Asia Central Banks; SEANZA= South East Asia, New Zealand, Australia. CMI = Chiang Mai Initiative; ABMI= Asian Bond Market Initiative; ABF = Asian Bond Fund; AFMM = ASEAN Finance Ministers’ Meeting; ACGM (ACBF) = ASEAN Central Bank Governors’ Meeting (ASEAN Central Bank Forum); ACMF = ASEAN Capital Market Forum;

63

The surprising element that emerges from a close look at these organisations and their

work programs is the range and extent of the apparent commitment to collaborative work

on financial integration issues. If these pronouncements could be taken as truly

reflecting a political commitment in the member economies to implementation of steps

toward financial integration there would be grounds for optimism about how quickly

things could change. The following description of the major regional cooperation

initiatives illustrates the point.8

Under the ASEAN Finance Ministers Meeting (AFMM) there is a formal ASEAN

Surveillance Process (ASP) which produces an annual report and is supported by the

ASEAN Finance and Central Bank Deputies’ Meeting, its working groups, the ASEAN

Surveillance Coordinating Unit and the ADB. While its focus is mainly macro-economic it

also is reports on financial stability issues. ASEAN also has an ASEAN Central Bank

Forum at Governor level and has established the ASEAN Insurance Training and

Research Institute and the ASEAN Insurance Regulators’ Forum. In a series of summits

since the Hanoi Action Plan 0f 1998 ASEAN has recognised the need for a Roadmap for

Integration and has worked towards defining a goal that is currently enshrined in Vision

2020 and includes the idea of an ASEAN Economic Community. As part of the process,

the AFMM adopted a Roadmap for the Integration of ASEAN in Finance covering four

areas: capital market development; capital account liberalisation, financial services

liberalisation and ASEAN currency cooperation.

To facilitate financial services liberalisation the Hanoi Plan of Action called for intensified

negotiations under the ASEAN Framework Agreement on Services (AFAS) and several

rounds of negotiations have taken place. A Fourth Round of Negotiations under the new

positive list approach is expected to conclude by the end of 2007. To date the

commitments have been criticised as being somewhat less than WTO (Stephenson and

Nikomborirak, 2002) but it is never easy to assess the value of commitments alone,

since they often lag behind the actual state of regulation and implementation.

To support capital market development two approaches lie at the core of the Roadmap:

i) institutional capacity building in areas necessary for the development of capital

markets including the legal and regulatory framework, market infrastructure, and

international best practices: and ii) initiatives to foster greater cross-border collaboration

64

between capital markets in the region including the development of market linkages and

harmonisation of capital market standards. In the Vientiane Action Plan three areas of

financial cooperation were explicitly identified: a) strengthening surveillance

mechanisms, including setting up an early warning system b) enhancing domestic

financial systems particularly in the areas of legal and regulatory systems, risk

management and market infrastructure and adoption of international codes and

standards and c) developing and integrating financial markets, through the

establishment of a regional network for capital market research and training, cross

border collaboration to develop common conventions in debt and equity markets; and

progressive liberalisation of financial services and capital accounts. At the same time

the ASEAN Capital Market Forum (ACMF) was established to focus on the development

of regional capital markets and was intended to be a meeting place for capital market

regulators. Significantly, the ASEAN Finance Ministers set up the ASEAN Exchange

Linkages Task Force to explore methods of linking securities exchanges in the region.

Areas identified as high priority are: narrowing gaps in technology, platforms, market

practices, and strengthening investor protection through, among other measures,

harmonising disclosure standards. The Task Force also began to benchmark the

“ASEAN 100” top listed companies across the major exchanges and developed an

ASEAN Index, launched in London in 2005. The ACMF has agreed to cooperate on

harmonising standards that would facilitate integration such as disclosure standards,

distribution rules, accounting and auditing standards and cross-recognition of

qualifications of capital market professionals.

Since 1999 the ASEAN+3 process has been institutionalised and includes a Finance

Ministers’ Meeting (AFMM+3) with four major pillars: the Economic Review and Policy

Dialogue; the Chiang Mai Initiative; the Asian Bond Market Initiative and the ASEAN+3

Research Group. The ERPD is mainly concerned with surveillance on a macroeconomic

level and does not concern us here. The Chiang Mai initiative and the ABMI are by now

so well documented that there is little need to describe how they operate. There is no

doubt that both are significant contributions to the institutional structure helping to build

closer financial links in the region. The first (CMI) provides liquidity support via a system

of bilateral currency swap agreements, in addition to what is available through the IMF,

and is presently being extended by new bilateral agreements at a rapid rate. Discussion

is under way on multilateralising CMI and changing the arrangements requiring IMF

65

supported programs for large calls on the facility. In 2006 the AFMM+3 set up a Group

of Experts (GOE) and an Economic Technical Working Group (ETWG) to find ways to

further strengthen regional surveillance and to develop an Early Warning System. Both

of these take on added significance in the context of the bilateral swap system of CMI.

The ABMI grew out of the perceived need to diversify sources of finance in the “bank-

dominated” (though note the earlier discussion about how meaningful this label is) Asian

economies and to help provide the infrastructure that would encourage and enable local

bond markets to develop. Alongside the Asian Bond Funds of the EMEAP there has

certainly been development of bond markets, though at present they mainly trade

government rather than private paper, and are still dominated by US dollar-denominated

bonds. The structures that support the ABMI (working groups on new securitized debt

instruments, credit guarantee and investment mechanisms, foreign exchange

transactions and settlement systems and credit rating systems) together with the

ASEAN + 3 Research Group have generated several studies that clarify aspects of the

integration agenda. While there has been criticism of the effectiveness of the Working

Groups there is a consensus that the ABMI has helped to diversify financing in Asia.

The EMEAP Asian Bond Funds (1 & 2) provide the demand side of the market and help

to build expertise and experience in managing and investing in bond funds.

Groupings initiated by, and centred on, Central Banks have also played a role in regional

cooperation on the finance agenda and have a long history in the region. SEANZA was

established in 1956, initially to provide training and capacity building. SEANZA now also

includes the SEANZA Forum for Banking Supervisors which has extended participation

to some functional regulatory bodies such as the Korean Financial Supervisory Service

and the Australian Prudential Regulation Authority. The forum is mainly an information

exchange mechanism though SEANZA also carries out training. This appears to be the

only regional body in which financial supervisors and prudential agencies meet to focus

on supervisory issues (rather than on central bank issues) and, in view of the growing

risks in financial systems, it might be useful to consider a higher profile and expanded

responsibilities for this body (or some alternative, see Recommendations below). Since,

as pointed out by Corbett (2007), many economies in the region still maintain functionally

separated supervisory bodies outside the Central Banks, there is a risk that the heavy

66

Central Bank and Treasury/Finance Ministry focus of the existing regional cooperation

bodies could allow supervisory issues to fall through the cracks.

SEACEN is principally a training and research centre, with a dedicated headquarters and

training facility in Malaysia. It runs large numbers of training courses using both in-

house and external resources and is financially assisted by the Bank of Japan. Several

non-member Central Banks have observer status.

The most recent of the Central Bank groupings, EMEAP, was a Japanese initiative to

strengthen cooperative relationships between members. Its structure (Governors’

meetings, Deputies’ meetings and Working Groups) was established in 1996. There are

three working groups: WG/PSS on payment and settlement systems, WG/FM on central

bank services and developments of foreign exchange, money and bond markets and

WG/BS on banking supervision. As noted above, since some member countries have

taken banking supervision out of the Central Bank (and in some cases have separate

supervisors for different market segments) EMEAP now includes representatives from

the financial supervisory agencies of some countries although it is mainly comprised of

Central Bank representatives. As we noted above and develop further below, this still

leaves a potential gap in the opportunities for information sharing and surveillance-type

activities in some countries and in several non-banking areas that are increasingly

important to financial systems.

Aside from its activities in establishing the two ABFs, EMEAP also provides training and

capacity building programs through the Bank of Japan (the EMEAP secretariat) and has

recently signalled its intention to raise its profile in the region. This raises the question of

where such training should be carried out and how these activities relate to those of

SEACEN. One limitation is that the CMLV countries and India are not members of

EMEAP.9

APEC also has significant programs in the finance area. One of the core principles of

APEC is to develop policy with a strategic goal (among others) that promotes stable and

efficient financial markets and supports greater economic cooperation, integration and

openness. The most recent Finance Ministers’ Meeting enunciated several initiatives

with finance content, including a Voluntary Action Plan on Freer and More Stable Capital

67

Flows, an extension of the Finance and Development Program, a Financial Regulators’

Training Initiative, a cooperative program for financial institutions for SMEs, a capacity

building training course for non-life insurance regulators, a program on Reform of the

Financial Sector (to include an online repository of finance-related information and

experience for finance ministers, central bankers and financial regulatory agencies), a

public-private dialogue on Bond Market development and a capacity-building initiative to

offer technical assistance on capital market development. As with EMEAP, the CMLV

countries and India are not members of APEC.

The most recent cooperation initiatives in the region are the Asia Cooperation Dialogue

and the East Asian Summit. At present the ACD covers a wide group, going beyond the

East Asian and Pacific region to include South Asia, Central Asia and the Middle East. It

is a loosely-structured and informal group that operates through dialogue and projects.

The Ministerial Meetings are usually attended by Foreign Ministers but there is the

possibility of extending the interactions under the ACD to finance ministers, central

banks, security regulators and stock exchanges. Amongst the nine project areas

recommended for consideration by Ministers, financial cooperation is included. Thailand

is the prime mover for the financial cooperation project and has set up a Working Group

on Financial Cooperation. Asian bond market development is the main focus of the WG

and the purpose is to build support for the activities of other fora such as EMEAP, rather

than to duplicate efforts. The Dialogue group has focussed its main attention on energy

issues (since it includes the Middle East this is an obvious natural advantage) and has

deliberately linked its initiatives to those of other bodies in a collaborative fashion while

bringing in a wider membership. The EAS, at present, somewhat resembles the ACD in

that it is a dialogue process with a wider membership than most existing East Asian

groups but its agenda is not yet clear.

It is difficult to assess the prospects for any of these groups since, while their agendas,

initiatives and work programs look well-directed to the problems of the region there is a

salutary lesson in the fate of the Manila Framework Group. Formed in 1997, it was

described in 2002 as “seen by some observers as the pre-eminent forum for regional

surveillance and peer pressure” (Wang for PECC, 2002) though Wang went on to

caution that the MFG had not been very successful as a mechanism for regional

financial cooperation because it had not clearly specified its priorities, it had no peer

68

review process but was limited to discussion only, and had no clear focus on financial

issues. Its membership was also limited. Sure enough, by 2004 the MFG had been

wound up.

Private-sector cooperation initiatives

In addition to the government bodies outlined above, there are a number of private-

sector or semi-government/multilateral regulatory bodies in which regional financial

market actors meet.

For securities markets there is the Asia-Pacific Regional Committee of IOSCO (and, as

noted above, the ASEAN Capital Market Forum). Most information sharing between

securities market regulators, however, is done on the basis of bilateral MOUs. Within

IOSCO 90 countries and regions signed more than 1000 MOUs for bilateral

cooperation10 and nine Asian economies have become, or have committed to become,

signatories to IOSCO’s Multilateral MOU, the first global information-sharing

arrangement among security regulators. The East Asian Stock Exchanges Conference

(EASEC) was founded in 1982 to facilitate the exchange of information among member

exchanges. In 1990, seventeen of the region’s stock exchanges (Australia, Shanghai,

Shenzhen, Hong Kong, India National, Mumbai, Jakarta, Surabaya, Tokyo, Osaka,

Korea, Kuala Lumpur, New Zealand, Philippine, Singapore, Taiwan and Thailand)

formed a grouping (EAOSEF) that changed its name in 2005 to the Asian Oceanian

Stock Exchanges Federation (AOSEF). Its activities include dialogue and research and

it has developed proposals on cross-border trading, market linkages, demutualization,

corporate governance, information management and harmonization and coordination of

listing, trading and clearing, and market surveillance. These proposals have apparently

been discussed within the organization but not necessarily advanced to government

policy levels and it is not clear how they can be implemented since they will depend on

voluntary adoption by member exchanges yet they would require coordinated

supervision and, in some cases, legislative support. Progress on the ASEAN initiative,

noted above, to commit to develop an inter-linked ASEAN securities market by 2010 will

be an indication of how these problems can be solved. 11

Despite these potential difficulties there has been some practical progress toward

linkages between some regional exchanges12. In addition to bilateral links, the TSE

69

announced an intention to cooperate with stock exchanges of 10 Asian cities in 2002 on

researching a system for the mutual free transactions of stock and bonds listed in the 11

stock exchanges and for promoting cross listings. It is not yet clear what progress has

been made13.

There are other forms of cooperation among independent organizations in the securities

industry, such as the Asian Securities Forum and the Asian Securities Analysts

Federation and financial institutions also play an active role. For example, five major

Asian Securities Houses from four Asian economies formed the first Pan-Asian online

stock exchange network, the Asian Stock Exchange Network, in April 2000.

In other market segments there is a similar growth of regional groupings. Depository

insurance corporations formed the Asian Regional Committee of the International

Association of Deposit Insurers. Credit rating agencies formed the Association of Credit

Rating Agencies in Asia (ACRAA) and there is a Forum for Asian Insolvency Reform.

The main purpose of these bodies is to promote dialogue, information exchange and

capacity building. The derivatives industry, still relatively underdeveloped in the region

and heavily concentrated in Singapore, established the Asian Pacific Association of

Derivatives (APAD), in 2004; an organization comprising academics, practitioners and

regulators to promote research and increase knowledge of the use of derivative

securities and markets.

The Financial Stability Forum, serviced by the BIS, also occasionally convenes regional

meetings bringing together regional central banks, finance ministries and capital market

regulators as part of its global program promoting information exchange.

Gaps in regional cooperation?

It emerges from the description above that, while there are several overlapping groups

exchanging information, they are many and varied. It is bound to be difficult to

coordinate across the groups and to share information emerging from one forum with

(differing) members of other groups. Moreover, the structure of the government level

groups seems based around a view of financial systems that does not reflect the realities

of the region. Consisting mainly of Central Banks or Finance Ministers or of deputies of

these groups, they may not be able to capture the complex nature of financial market

70

regulation in a changing world and across varying systems. Enhanced communication

across the groups and greater public-private sector dialogue would be useful.

Financial regulation within the region and around the world does not display a uniform

structure. With the growth of integrated financial service provision and the wave of

mergers creating large financial conglomerates, many countries have questioned

whether the supervisory arrangements of previous decades are still appropriate. The

pace of financial innovation has increased, financial conglomerates are not only complex

organizations to supervise but also change the way in which risk is transmitted within the

financial system. As a result both the risks in the system, and the regulatory objectives,

have become more complex. The response around the world has been to consider

whether regulators should also be consolidated into integrated bodies that deal with

many previously-separate financial sectors. This has implications for the role and

structure of regional cooperation for a.

There are many variations of the model of unified and integrated agencies (Llewellyn,

2006). Unified agencies cover not only prudential supervision but also “conduct-of-

business” supervision (i.e. consumer and investor protection issues such as disclosure,

fairness etc). There is a spectrum of agencies, with some covering more than one, but

not all, parts of the financial system (e.g. the Australian system where APRA supervises

banking and insurance but not the securities industry). The “twin peaks” model has two

bodies, one to carry out prudential supervision and the other to do “conduct-of-business”

supervision (again Australia is an example). Under this model there is always the

question of whether the Central Bank should become the prudential supervisor across

the whole financial system, though this may have the risk that safety nets become

extended to areas beyond those for which they were originally designed. The role of the

Central Bank is an important one, and particularly so in East Asia, where many countries

still rely on the Central Bank for supervision.

There is a very wide range of supervisory models around the world. Around a third of

countries have a single, integrated prudential supervisor (like the FSA of Britain), a

small proportion have supervisors that combine a couple of financial sectors and over

40% have specialist, multiple supervisors dealing with only one financial sector

(Llewellyn, 2006; Cihak and Podpiera, 2006) Thus, the majority of countries are still

71

supervising separately but the striking feature is how varied is the international

experience.

Table 15 Supervision Structures Around the WorldFully Integrated 39

Central Bank 9

Other 30

Partially Integrated 23

Banks and Insurance 9

Banks and Securities 5

Insurance and Securities 9

Separate 43

TOTAL 105

Source: Llewellyn, 2006

There is, however, an increasing trend to integrated financial supervision (Barth et al,

2006) thought interpretations of how to classify countries vary widely. The World Bank

survey of regulators suggests that 11 out of 32 countries in the Asia Pacific region have

a single supervisor for the financial sector. In addition, some countries have multiple

supervisors for one type of financial institution (typically banks).

Within East Asia the picture is equally varied. Table 16 gives details of East Asian

supervisory arrangements.

TABLE 16 SUPERVISION IN EAST ASIA

Integrated Banking & Securities

Banking and Insurance

Securities and Insurance

B, S, I separate

Central Bank supervises banks?

Singapore(1984) YesMalaysia (1988)

Y

Japan (1998)Koreae (1999) NTaiwane (2004) N

China e NHong Kong YIndonesiaa Y

72

Philippinesb YThailand c,e YLao d YCambodia YVietnam Y

Asutralia(1998)

N

India YNew Zealand

N

Notes: a) Designing and debating a single regulatorb) Two banking supervisorsc) Banking supervisor also covers asset management and other financial servicesd) Not clear where securities would be regulated as the market does not yet existe) Barth et al, 2006, classifies these as having multiple bank supervisors

Source: Corbett, 2007, updated

The division within the East Asian region is broadly along income lines, with the higher

income group mainly having moved, mostly quite recently, to the integrated supervision

model. There are few studies of why countries choose integrated supervision nor many

empirical studies of the impact of integrated supervisors. This partly explains why there

is no consensus view about what system works best. The present World Bank view is

that different countries may well need (or be able to get by with) different systems.

Importantly they also stress that the transition from multiple, specialist supervisors to

single, integrated supervisor is a complex process that can be costly and difficult

(Martinez and Rose, 2003)14.

What this means for discussions of East Asian regionalism is that information exchange

and coordination of views will be made more difficult by the fact that different types of

regulators, with different expertise and regulatory philosophy, are involved. Under the

current structure of regional cooperation bodies, some of these regulators are not

included in the dialogue mechanisms because of institutional definitions that do not

match the realities. Central Bank groups may not be able to adequately cover regional

prudential issues if the prudential regulators are not represented. With increasing

consolidation in the financial sector, banking prudential issues cannot be fully divorced

from risks in the securities industry but they cannot be fully addressed if the separate

securities regulators are not included in the dialogue and surveillance mechanisms. So

an obvious proposal to add to the regions’ arsenal in the financial sector is to create a

wide-ranging Financial Supervisory Forum that includes the full range of supervisors and

discusses the new supervisory challenges that arise from both the trend to financial

73

conglomeration that blurs boundaries between market segments and the trend to cross-

border activities that blurs the boundaries of national regulation.

Harmonisation and Mutual Recognition

Several of the private sector regional groups (and some of the government ones) make

mention of the desirability of harmonisation of standards. This is frequently cited as a

desirable step towards closer financial integration but it should not be assumed to be an

easy one. The aim of harmonisation of standards is to ease the difficulty of regulating

activities across different systems and regimes, to lift the burden of enforcing regulation

across jurisdictions and to increase the familiarity of systems so that investors,

consumers and service providers face lower information and transactions costs. There

are broadly three models for regulating cross-border financial services (see Corbett and

de Brouwer, 2005, for a more complete version of the following arguments). First,

countries can engage in full harmonisation, in which the participating countries adopt the

same set of rules. Second, governments or self-regulatory bodies can agree upon a

system of mutual recognition, which requires weak harmonisation as a basis, but leaves

more discretion to the individual economies. Finally, private insurance can be used in

lieu of formal legal systems, to create a system of self-regulation of financial services

that compensates for failures but doesn’t try to regulate them away.

Each of these models has benefits and difficulties in terms of both efficacy and the ability

to ensure the aims of consumer and investor protection and financial sector stability.

Harmonisation requires the development of laws or treaties that govern activity in each

of the members of a regional group. This approach is in many ways the most difficult of

the three regulatory models, as it requires implementation by all of the national

governments concerned and involves the acceptance of rules negotiated elsewhere and

the loss of a degree of sovereignty. There are different levels of rigour with which

harmonisation can be imposed. In minimal harmonisation regimes the states decide on

a minimum set of standards, leaving it up to individual countries to adopt more extensive

regulations if desired. Full harmonisation leaves less open to chance at the national

level, and imposes a higher set of standards. The challenge with harmonisation comes

from the difficulties of enacting appropriate rules that are accepted and enforced by all

participating countries. Negotiating legislative tools at the international level is a

complicated, time-consuming, and costly project, and not necessarily one that

74

governments are ready and willing to enter into. Rules have the advantage of providing

a predictable, and clearly understood, regulatory regime but harmonisation may also

remove the competitive market pressure of regulatory arbitrage that forces countries to

respond to ‘best practice’ developments elsewhere. And, at the end of the day, the rules

must be enforced at the domestic level to make harmonisation operate.

Mutual recognition is similar to harmonisation in that it relies on the state for its

enforcement. While harmonisation requires participating countries to adopt laws

containing the same standards and regulations, mutual recognition only requires states

to recognise minimum standards for market participants, allowing regulators to assume

that financial services firms in other countries have met certain quality and other

requirements. It is based on the notion of home country control. In other words, the

firm’s home country is responsible for regulating its activities, and must abide by certain

minimum standards set by the countries as a group. Other countries must then

recognise the validity of the home country’s approach.15

The main benefit of the mutual recognition model is its relative informality, at least

compared with full harmonisation schemes. The best existing example of a mutual

recognition system in financial services is the European Union, where the model has

been applied directly to the problem of cross-border business-to-consumer financial

services.16 The European Union has adopted a number of Directives in the financial

services area based on the notion of mutual recognition. These Directives state that

authorisation in one Member State to provide banking or investment financial services,

serves as authorisation to provide those same services in any other Member State,

subject to compliance with the provisions of those Directives (the “Banking Passport”

notion). Services covered by this regime include investment services, (securities

brokerage and underwriting), and dealing in over-the-counter financial derivatives.17 In

1987, a directive provided that if the listing particulars of an issuer of equities or mutual

funds were approved by authorities in one Member State, that they must be recognised

in other Member States without additional scrutiny. This directive was a first step

towards reciprocal recognition of financial services rules in the European Union.18

75

The Investment Services Directive (the “ISD”) was a further step in this direction. The

ISD applied generally to any firms in the business of providing investment services,

including brokerage, dealing, market making, portfolio management, securities

underwriting, and individual investment advice.19 (Other Directives also provide mutual

recognition for financial services within the European Union.) The EU experience with

the ISD shows the problems these systems can encounter, and that, eventually, deeper

harmonisation may be necessary. Any legislation that refers to developing technologies

suffers from the risk that it will be obsolete by the time it is effective. Ultimately

technological and other developments caused the ISD to be outdated very rapidly:

“The ISD, pivotal to the integration of the investment services market, was nevertheless designed in

1992 for an era when the underlying securities and money markets were heavily fragmented by ex-

change risk and where national exchanges were the uncontested point of liquidity for local securi-

ties. Now national exchanges are facing increased competition in their core business from alternative

trading systems and globalisation. Markets are pressing for European-level consolidation of clearing

and settlement and retail investors are increasingly seeking to trade securities directly for their own

account.” 20

The Financial Services Policy Group of the Commission has proposed that revision of

the ISD should focus on cross-border provision of investment services, taking account of

competition with traditional exchanges from electronic trading alternatives, and the

difficulties presented by the consolidation of clearing and settlement procedures.21

On a more general level, mutual recognition schemes are open to the danger that

consumers will only be able to rely upon the lightest of regulatory regimes, and that the

nature of consumer protection will thus fall to the lowest common denominator.22

The answer to the problems of mutual recognition is not necessarily full harmonisation,

but may in fact be less harmonisation. An alternative is not strictly “regulation” at all, but

rather a reliance on private contracting between firms, or self-regulation. This may

involve third parties providing alternative dispute resolution mechanisms (e.g. mediation

that does not go through courts or rely on regulators for enforcement). By obtaining

insurance for individual transactions, banks and brokerage companies may be able to

create a transnational market for financial services that does not rely on recourse to

regulatory remedies in the event of problems. Financial services firms would be

76

responsible for obtaining private insurance for their services, such that the participating

governments would allow these firms to do business on a cross-border basis. However

the mechanism for creating a standard accepted by the governments is unclear, and

may run into the same problems met by full harmonisation and mutual recognition

approaches. The message is that glib recommendations that harmonisation or mutual

recognition is needed within the region underestimate the difficulties. While it may be

desirable to begin a process to achieve these aims, integration can and will proceed

before they are fully realised.

VI Conclusions and policy recommendations

We have argued that integration is hard to measure in quantitative terms and, while

regional integration still looks low by conventional measures the pattern is varied across

countries and markets. At the same time there are many elements of growing

interdependence in the financial sector and there are multi-faceted attempts at closer

regional cooperation.

If progress is slow this reflects the fact that development priorities differ across the

region (because of differences in income levels and other development gaps). It also

reflects the fact that some economies and some groups within economies remain

somewhat ambivalent about the goals of financial integration.

In this situation, it is unrealistic to discuss progress in terms of integration of the type

defined by the European Central Bank 23, which considers the market for a given set of

financial instruments or services is fully integrated when all potential market participants

in such a market i) are subject to a single set of rules when they decide to deal with

those financial instruments or services – common rules

ii) have equal access to this set of financial instruments or services– common access

and

iii) are treated equally when they operate in the market - common treatment.

In the present situation in the Asian region it is more realistic to consider more limited

objectives, such that i) capital can move freely within an economic area ii) issuers are

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free to raise capital anywhere within the economic area and iii) investors can invest

anywhere within the economic area. Further, we might wish to establish that financial

service providers can operate in any market in the region without barriers to entry based

on nationality. Even these goals will take a considerable time to establish and therefore

one should be measuring success in terms of movement in the direction of open and

integrated markets rather than attainment of specific objectives.

Specific recommendations are regularly being made in research papers and reports but

there are some that seem either more achievable or more fundamental than others and

therefore recommend themselves as high priority next steps.

Recommendations:

1 Training programs are currently being provided under a number of initiatives but there

does not seem to be a rigorous, disinterested assessment of their quality. A review of

training and capacity building programs across the range of regional fora could suggest

ways of raising quality and reducing duplication. (Corbett and de Brouwer, 2005)

2 Surveillance processes are frequently identified as weak because they lack

mechanisms to make policy recommendations and to carry out tougher assessments of

national policies. There are now several surveillance mechanisms and processes and a

review of the effectiveness of these would help to identify whether one regional forum is

better placed than others to carry out surveillance or whether outside/independent

bodies are best suited to the task.

3 There is a need for a regional forum to bring all financial regulators and supervisors

together, recognising that different structures in different countries mean that currently

not all the relevant regulators meet in the existing fora. It may be that one of the

existing supervisors’ fora can be expanded to carry out this function but there is strong

evidence that the widest country grouping possibly would be the best basis on which to

build this structure. ( ASEAN Secretariat, 2007, Cowen et al, 2006, Wang 2002). There

is also a need for more consistent interaction and exchange of views between the public

and private sectors (Corbett and de Brouwer, 2005)

4 Building on the initiatives to link stock exchanges in the region together there may be

merit in considering building an equity market equivalent to the ABMI (Yap, 2007

suggests an Asian Investment Corporation)

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5 While there is a general sense that there is still considerable room for improvement in

the level of domestic financial sector reform the data are patchy and inconsistent.

Dobson (2004 and 2006) notes the need for timely and complete information on financial

reforms - both domestic and regional. She points out “there is still no region-wide,

publicly available evaluation of domestic reforms against best practice benchmarks and

in terms of remaining gaps in implementation that need to be addressed. What do we

know about the competitiveness of the region’s banking sectors? What do we know

about governments progress in regulatory and supervisory reforms?...” (2004, p 6). In

part this arises because the participation in the FSAP and ROSC processes is low. If

there is resistance to taking part in IMF processes then building something similar into a

strengthened regional surveillance mechanism could provide needed benchmarks.

(Cowen et al make a similar point in calling for “efforts to harmonize rules and practices

across the region and with global standards and best practices. In this regard, FSAPs

and ROSCs could be useful instruments to benchmark Asian countries against best

practices and identify priorities for reform.” )

6 As noted in the section on regional organizations, it would be useful to have

information on work programs organised by topic or market segment so that it would be

easy to discover under the heading say of “liquidity support” or “capital market rules

harmonisation” which groups were working on what elements. Such a database would

not be very difficult to compile and could be kept up-to-date by agreement across the

various organisations. It could usefully reside at the ADB ARIC website.

7 Cowen et al (2006, p32) add the need for

1 Note the data issue remarked under the chart and table below – it is not clear where these data have been sourced and why they are not fully consisten

2 A recent conference described the situation: “Bancassurance in Asia has been a relatively recent phenomenon, drawing increasing attention as a rapidly growing distribution channel for insurance only since 2002. Notwithstanding its short history, bancassurance penetration in the region has increased tangibly to capture market shares in excess of 20% of life premium in the more developed bancassurance markets within Asia”. (6th Annual Bancassurance Asia conference (http://www.marcusevans.com/events/CFEventinfo.asp?EventID=11113).

3 The World Bank 2006 study is fairly complimentary though still listing a number of policies that are needed to move further. The IMF is less so. Kramer (2006 Finance and Development, Vol 43, no 2) notes that “ the perceived ranking of the governance environment is weaker than it was before the crisis. Along six different dimensions—voice and accountability, political stability, government effectiveness, regulatory quality, the rule of law, and control of corruption—emerging Asia ranked lower in 2004 than in 1996 (see Chart 3).”

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“• Work to establish regional infrastructures such as clearing and payment systems,

credit

rating agencies, and benchmarks to complement ongoing initiatives such as the

ASEAN Financial Roadmap and work in EMEAP

and importantly

• Coordination in crisis management. As institutions become active in a number of

jurisdictions, crisis management becomes more complicated. Without touching on more

intensive, and politically sensitive issues such as solvency support, much could still be

done at the technical level to coordinate crisis management and contingency plans. This

could involve protocols to share information and resolve practical issues such as public

communication, and payments and settlements.”

8 Since these days an important element of financial liberalisation is incorporated in

trade agreements in services, more attention needs to be paid to developing best

practice in services agreements and to addressing the potential problems of the bilateral

approach to negotiating them.

Conclusion

The evidence is that the East Asian economies, despite progress in domestic market

liberalization and, to a lesser degree, capital account opening, have achieved only a

modest degree of regional financial integration to date. The extent of their engagement

with global financial markets has grown considerably, though by some measures, is still

low relative to the size of their GDP. Several initiatives have developed over the last 10

years geared towards increasing regional financial cooperation. The effect of these

developments and of the proposals we have included here, may not be the result that is

currently hoped. Nevertheless, such domestic and regional efforts will be worthwhile.

The nature of regional financial integration is complex. Patterns vary across different

regional groupings and there is no unified theory of optimal financial areas that would

parallel optimal currency areas. Furthermore, the evidence on the extent to which fully-

open financial markets benefit economies is somewhat harder to read than the same

evidence on trade openness so there is an important public education task to do. The

consensus is that more open and liberal financial systems will ultimately lead to more

developed, and deeper, systems and will help achieve efficiency, growth and, probably,

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stability. The transition to reach those targets is difficult – both sequencing and scale

matter. Progress must be careful, and to some degree measured (if not slow), yet half

measures are probably worse than no measures. Once openness is achieved there is

no theoretical, or empirical, reason to predict that the direction of integration with

external financial systems will favour near neighbours or regional groups. To some

extent geography matters, and the East Asian region does not have the geography that

promotes regional integration. History also matters, and entry into a world in which

dominant financial centres and institutions already exist in Europe and North America will

skew interactions towards those centres. Trade relations matter and, while regional

trade has been important in Asia, the importance of wider, global trading relations is

greater here than in some other regions. Relative to the degree of regional trade, Asia

has probably achieved quite a significant level of financial integration, but it is unlikely to

match some other, more intensely internally-traded groupings such as Europe.

Does this mean that there is no point to regional efforts to enhance financial

performance among member economies. No, it does not. There is little doubt that

having strong, deep, well-regulated financial markets will improve growth, risk sharing

and welfare in the region. Whether those markets, once established, interact more with

global financial centres and institutions or more with regional ones will be ultimately a

market decision. But the transition to stronger financial systems requires domestic policy

actions that can be boosted by regional encouragement and support. As Kaminsky and

Schmukler note “The evidence suggests that institutional reforms do not predate liberalization.

Most of the time, government reforms are implemented within a few years after the partial

opening of financial markets. As the quality of institutions improves, financial cycles become less

pronounced. Perhaps due to lack of correct incentives, countries do not tend to improve their

financial systems before liberalization, disregarding the typical policy prescriptions. Harmonisation

with global standards and implementation of best practice will be more easily achieved with

regional cooperation and information sharing.” (p 37)

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APPENDIX

82

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Source: Julius Caesar Parreñas, 2007, “Financial Liberalization and Integration in East Asia: Challenges, Prospects and Cooperation Opportunities” ABA Journal, Vol. XXII, No. 2, pp ?

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4 For example, a country with 1% of the world’s wealth in a world of perfectly open capital markets would hold 99% of it’s assets abroad. 5 There is evidence that this “finance follows trade” effect occurs in other countries too (Lane & Milesi-Ferreti, Rose and Spiegel 2002 cited in E&P, and Portes and Rey, 2005). 6 The famous result of Feldstein and Horioka showing high degrees of correlation has been challenged but is largely replicated for many countries and time periods. 7 “ Within Southeast Asia, the Association of Southeast Asian Nations (ASEAN) establishedthe framework agreement on services in 1995 (amended in 2003), which incorporated byreference the GATS Annex on Financial Services. The ASEAN Finance Ministers have thusfar concluded a third round of negotiations on liberalization of financial services under thisframework, and the fourth round, which started in April 2005 is scheduled to be concluded in2007.” Parrenas, 2007, p 3 8 The information about the organisation and activities of the regional cooperation fora is taken from ASEAN Scoping Study produced in conjunction with the Australian Treasury which is, in turn, based on information from the websites of the ASEAN Secretariat, the ADB’s ARIC , the SEACEN website, the EMEAP website and the ACD website (www.acddialogue.com )9 Most of the information of the preceding paragraphs came from the sources noted in footnote 9. 10 China’s CSRC had signed 37 MOUs with 34 economies by June 2007, including 9 within the region.Hong Kong’s SFC had concluded 44 formal cooperative arrangements with 33 overseas regulators by June 2007, including 10 within the region. 11 The experience from the ABMI illustrated the variety of difficulties that needed to be overcome when operating across a number of different jurisdictions even though that initiative had high-level support from member economies’ governments, finance ministers and central banks. 12 These include an SGX-TSE strategic alliance in October 2001; an ASX-SGX co-trading linkage in December 2001; TSE and KRX signed “Memorandum of Intent” of cross-border securities trading in August 2005; TSE and KRX signed a Memorandum of Understanding (MOU) on the "Market Alliance Project" on July 7, 2006 and TSE spent about $304 million to buy a 4.99 per cent stake in the SGX in June 2007. 13 Though there are a growing number of examples of cross listing. Eighty-one Chinese companies were listed in eight main overseas markets, raising 20.4 billion US dollars in 2005. The figures were 86 and 44 billion US dollars in 2006. 340 mainland-based companies have been listed in Hong Kong and105 mainland-based companies have been listed in SGX by August 2006. However, according to IMF Asia-Pacific Regional Outlook (September 2005), while some stock markets in the region have attracted a large international presence, this is mainly not from within Asia.14 These paragraphs are drawn from Corbett, 200715 Robert J. Coleman, “Financial Services and Consumer Policy: The Regulatory Challenge” for European Banking & Financial Law Journal (2001. 16 The European Union first moved towards a mutual recognition approach in 1979 in the case of Rewe-Zentral AG v. Bundesmonopolverwaltung für Branntwein (commonly referred to as “Cassis de Dijon”), in which the European Court of Justice established a principle based on the freedom of goods between Member States, that if goods could legally be marketed in a Member State, then they also could be exported into and sold in another Member State, unless restricted by a specific provision in the EC Treaty or a requirement justified in the general good. This holding mean that Member States should respect the

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adequacy of other Member States’ laws with respect to the marketing of products. Andrea M. Corcoran and Terry L. Hart, “The Regulation of Cross-Border Financial Services in the EU Internal Market: A Primer for Third Countries” (2001), 15.17 Andrea M. Corcoran and Terry L. Hart, “The Regulation of Cross-Border Financial Services in the EU Internal Market: A Primer for Third Countries” (2001), 17 (citing the Consolidated Banking Directive).18 Karen M. Smith, “The Need for Centralised Securities Regulation in the European Union” (2000) 24 Boston Coll Int’l & Comp L Rev 205, 209; Council Directive 87/345/EEC of 22 June 1987 amending Directive 80/390/EEC coordinating the requirements for the drawing-up, scrutiny and distribution of the listing particulars to be published for the admission of securities to official stock exchange listing. 19 Council Directive 93/22/EEC of 10 May 1993 on investment services in the securities field.20 European Commission, “Financial Services Policy Group reviews Action Plan and discusses investment services reform and E-commerce” (15 May 2000). 21 European Commission, “Financial Services Policy Group reviews Action Plan and discusses investment services reform and E-commerce” (15 May 2000).22 Robert J. Coleman, “Financial Services and Consumer Policy: The Regulatory Challenge” for European Banking & Financial Law Journal (2001). 23 ECB uses this definition to design a set of quantitative indicators of financial integration and monitor the progress of integration in its 2007 annual report on “Financial Integration in Europe”

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