GLOBAL financial DEVELOPMENT REPORT 2013
a recent joint report by FSB, International Monetary Fund (IMF), and World Bank (2011), endorsed by G-20 leaders in the Cannes Summit, calls for countries that have less internationally integrated financial systems or substantial constraints in supervisory capacity to focus on reforms to ensure compliance with the more basic principles of sound regulation before considering a move to the Basel II and Basel III standards. The same report also calls for further development of supervisory capacity in developing economies through targeted and well-coordinated technical assistance and other capacity-building activities. These efforts need to be part of a broader, sustainable strategy to overcome capacity constraints in regulation and supervision in developing economies. Strengthening of supervisory capacity and improvements in regulations are areas where donors can provide help. One of the tools in this regard is the Financial Sector Reform and Strengthening (FIRST) Initiative, a multidonor grant facility managed by the World Bank. Strengthening supervisory capacity and improving regulations account for more than a half of FIRST’s recent projects. Individual donors have also provided support directly to various projects aimed at strengthening capacity in regulatory agencies. For example, the State Secretariat for Economic Affairs (SECO) in Switzerland has an extensive program of banking sector training in Vietnam, which includes practical training for the regulatory body, complemented by a train-the-trainer project for Vietnam’s two largest universities, management training for bank managers, and technical assistance in modernizing the central bank and its strategy to develop the banking sector. (For information on SECO’s programs in the area of capacity building, see the relevant background materials at http://www.worldbank .org/financialdevelopment.)
Weaknesses in market discipline and the role of incentives Before the crisis, financial systems in many jurisdictions (especially advanced economies,
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but also some emerging markets) relied on market discipline to safeguard financial soundness and stability. Market discipline requires that markets objectively assess the risks and value of financial instruments and financial institutions, and price them accordingly. The crisis has made it clear that such objective market valuation does not always occur. For example, in the first half of 2007, the stock market valuation of Irish banks was at or close to their long-term maximum. Also, spreads between Greek debt and German bund were very small for years, as were the spreads of other euro area countries, not providing much indication of what was to take place. Similarly, credit default swap spreads for southern European countries were negligible for many years compared to their peers in Northern Europe, which allowed some countries to go on a lending binge for many years. It was only through the economic slowdown during the crisis and escalation of events in Greece that market perceptions started to change substantially and credit default swap spreads on government paper shot up (and became more closely correlated with bank risk measures). These observations are reminders of the tendency of economic agents and the financial system to be overly tolerant of risk in credit cycle upswings and excessively risk averse in downswings. Put differently, the failure of market discipline needs to be seen against the collective tendency of financial markets to underestimate risks in boom times and overestimate it in times of bust. Still, the failures of market discipline in the run-up to and during the crisis do not mean that financial markets did not provide useful signals. As shown for example by Haldane (2011), equity markets were differentiating between banks in trouble and those that were not several years before the financial crisis, when intervention could have vastly reduced the subsequent costs. Papers that examined previous crises find similar relationships. Markets can provide useful signals, but the real question is, when do they provide such signals? And how can