DEVELOPMENT RESEARCH NEWS
the “real� side of the issue, more substance will be given to regional financial cooperation. Of course, the structure and configuration of the Asia Investment Infrastructure Fund still has to be threshed out, particularly on how it will relate to the Asian Development Bank. A broader agenda for regional cooperation is addressing weaknesses in the global financial system in order to improve its functioning and integrity. Measures in these areas can be usefully coordinated regionally along with initiatives from the G-20, the Financial Stability Forum, and the International Monetary Fund (IMF) in calling for detailed work programs on crisis prevention and crisis management. Based on the experience of addressing the Asian financial crisis as well as its spillovers, the region has a strong interest in contributing to the work programs and ensuring that financial systems will become less prone to crisis. Identifying reforms in the international financial architecture will enable various regional forums to coalesce common interests and project them in a global rules setting. This is a way by which regional financial cooperation can be sustained without expending a great deal of political capital. A logical outcome of this process is the identification of areas where regional and national reforms can support the global effort. ADB (2008) has provided a useful summary of the main issues at the international, regional, and national levels: Strengthening transparency and accountability Special attention needs to be paid to measures that would strengthen financial system transparency. This is in response to the problem associated with the opaqueness of complex derivative products and the lack of clarity on who holds the risks. Accordingly, disclosure of complex financial products and of the financial conditions of firms should be emphasized. Enhancing sound regulation and prudential oversight
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January - February 2009
Weaknesses and gaps in financial sector regulation and supervision arguably allowed excessive leverage and risk taking, and the buildup of significant off–balance sheet leverage in Special Investment Vehicles and other conduits. Accordingly, strengthening and broadening regulation and oversight can help address those features of regulatory regimes that may have contributed to the current turmoil. Regulators need to strike an appropriate balance between competing objectives such as fostering financial innovation and maintaining financial stability. In doing so, however, they need to resolve issues regarding regulatory gaps and ensure that all financial institutions and markets are subject to “appropriate� supervision or oversight. Mitigating procyclicality of financial systems Regulators should consider designing prudential regulation in a countercyclical fashion, including forward-looking risk evaluation and adequate liquidity provisioning to help avoid large financial swings and their destabilizing effects on the economy. Currently, most financial systems exhibit a high degree of procyclicality. For example, as a result of variations in specific provisioning and changes in perceived risk, the Basel II framework may lead to a situation where the amount of capital banks are required to hold declines during business cycle expansions and increases during contractions. Particularly in emerging market economies, excessive risk taking during booms— associated with large capital inflows and rapid domestic credit growth—is often the origin of a financial crisis. Maturity and currency mismatches on financial and nonfinancial balance sheets during booms also add severe strain on currencies and financial systems. Effective risk analysis by financial institutions, together with countercyclical and forward-looking prudential provisioning, will therefore help sustain financial stability through the down cycle.
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