Domestic Markets and Financial Stability in Emerging Economies

Mario BergaraCentral Bank of Uruguay

19th Dubrovnik Economic ConferenceJune 13, 2013

Domestic Markets and Financial Stability

Outline

On the Governance of Financial Stability Institutions

Domestic Markets and Financial Stability

Outline

On the Governance of Financial Stability Institutions

Foreign investors used to stay out of domestic markets:Lack of informationTransaction costsOperational risksLower creditor protectionOther macro issues

However, this fact is rapidly reverting

Lacking arbitrage, these markets were seen as stable sources of funding

In small emerging economies, domestic markets are essentially local bonds markets

What domestic markets are expected to do for financial stability?

Local Markets and Financial Stability

Underdeveloped domestic financial markets

Reliance on foreign funding and less capacity

to issue domestic currency debt

Overexposure to external shocks

Frequent non-country specific crisis and sudden

stops

What domestic markets are expected to do for financial stability?

Local Markets and Financial Stability

Reliance on external sources renders the country more subject to external shocks and non-country specific financial crisisLocal markets development as a means to reduce financial fragilityKeys to develop local markets and reduce currency mismatches:

Stronger institutionsWell defined creditor rightsLow inflation

More developed domestic financial market helps reduce the volatility of capital flows to emerging economiesHowever, domestic market development entails new problems when considering the impact on financial stability

What domestic markets are expected to do for financial stability?

Local Markets and Financial Stability

Implications of volatile capital flows formacroeconomic and financial stability

Growthdifferentials

Appreciating and volatile exchange rates in emerging markets

Uncertainty and volatility in the global environment

Interest ratedifferentials

Differentialexpectations onexchange rates

Liquidityconditions and

marketsentiment

Risks of asset price bubblesand bank lending boom

Risks of capital flowstop or reversal

Local Markets and Financial Stability

Inbound capital movements set the grounds for currency appreciation beyond the limits of other fundamentalsAnother secular trend of new markets discovery by massive investment funds adds further pressure on the exchange rateInvestment funds increasingly search for new alphas, encouraged by historically low interest rates and buoyant international liquidityNot only the real sector suffers, but is also subject to foreign and domestic sources of real exchange rate shocksThe domestic financial sector may be subject to solvency issues related to sharp changes in this relative price

Inbound capital might generate trends of currency appreciation

Local Markets and Financial Stability

As foreign investors find more attractive to enter domestic markets, they increase the aggregate demand for domestic assetsHigher demand implies higher prices and lower yields, making harder for the monetary authority to pursue an interest rate targetThe Central Bank is forced to perform sterilized purchases of foreign currency, to prevent sharp short term currency appreciation and to satisfy the demand for domestic assetsFX market tensions risk diverting the monetary authority from its primary target and might as well generate pressure on the financial system

Prudential regulation and supervision have to pay special attention to FX risk issues

Capital reallocation dampens the ability of monetary policy to cope with internal stabilization issues

Local Markets and Financial Stability

Central Banks in emerging economies have use reserve requirements and caps on foreign exchange positions to limit potential imbalances derived by surges in short-term capital inflows

Macroprudential instruments to limit the exposure of the financial system to systemic risks

Exchange rate flexibility acts as an automatic buffer to cushion against external shocks and contribute to provide an adequate incentive structure in the economy

Foreign exchange market intervention: reduce excessive volatility and currency appreciation in the current (circumstantial) financial environment, but not against long term fundamentals

The macroprudential perspective contributes with more instruments to deal with short term capital flows, without affecting macroeconomic and financial stability

Financial Stability and Policy Options

Local Markets and Financial Stability

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Globalization dampens the role of domestic markets as firewalls

Local Markets and Financial Stability

External financial episodes directly affect domestic interest rates, weakening the control by the monetary authority.As emerging markets yields tend to correlate, non-country specific financial distress equally produces domestic turmoilInvestment funds tend to follow pro cyclical herding behaviors in face of bad newsAs a result, while domestic financial markets tend to channel home-biased sources of funding in a stable fashion, their development and increasingly global arbitrage might generate some negative side-effects that may have consequences on financial stability if not correctly addressed.

Domestic asset prices are increasingly determinedby external factors

Local Markets and Financial Stability

Domestic Markets and Financial Stability

Outline

On the Governance of Financial Stability Institutions

Financial Stability in a context of Macroeconomic Stability

Micro and Macroprudencial Regulation

Monetary policyFiscal Policy

FinancialStability

Identifying relevant systemic risks and addressing externalitiesMonetary and fiscal policies can help to mitigate costs of aggregate weaknesses and individual failures“New issues” for Central Banks and Financial Regulators?

On the Governance of Financial Stability Institutions

The lack of a macro-systemic approach was clear, but was the micro-prudential regulation working properly?

Failure of the regulatory approach and of the organizational design of public intervention in financial marketsThe decentralized governance failed as well as the “light supervision” approachSupervision and regulation was poor and the organization of the Financial Safety Net was inaccurate in some places and chaotic in others

A possible (dangerous) lesson from the crisis: “Everything was right except that the macro-prudential approach was lacking.”

The discussion about the governance of macro-prudential policies might be “smuggling” a debate about the failure of the decentralized regulation and the need to move towards a more centralized fashion

We need to get back to the conceptual determinants of the optimal Financial Safety/Stability Net: conflict of objectives, incentive structures, accountability, coordination and organizational design

Current discussion influenced by situation in developed countries

On the Governance of Financial Stability Institutions

Monetary Policy

Lender of Last Resort

Prudential

Regulator and

Supervisor

Deposit Insurer

and Resolution

Agency

Explicit conflict of objectives, right incentivestructure, accountability and coordination

Financial Safety Net: Governance

On the Governance of Financial Stability Institutions

The decision-making of some crucial issues

Liquidatingfinancial institutions

Mergers andacquisitions

Short termfinancial assistance

Interveningfinancial institutions

Financial Safety Net: Governance and Conflict of Objectives

On the Governance of Financial Stability Institutions

Separation/Unification of theFinancial Safety Net agencies

Relative institutionalstrenght

Reputation andcredibility

Expertise andcapacities

Make explicit theconflict of objectives

Institutional Determinants of the Financial Safety Net Design

On the Governance of Financial Stability Institutions

The necessary consistency in supervisionand regulation across markets and agents

Capitalmarkets

Insurancemarkets

Pension fundadministrators

Financialintermediaries andnon-intermediaries

Degree of Centralization of Financial Regulation

On the Governance of Financial Stability Institutions

More centralized

Efficiency due tospecialization

Lower powerconcentration

Economies of scaleand scope

Lowerbureaucratic costs

Less centralized

Conglomerateslogic

Degree of Centralization of Financial Regulation

Lower regulatoryarbitrage

On the Governance of Financial Stability Institutions

Monetary Policy

Lender of Last Resort

Prudential

Regulator and

Supervisor

Deposit Insurer

and Resolution

Agency

Coordination and contribution for all agenciesto comply with their respective mandates

From Financial Safety Net to Financial Stability Net: Governance

Ministry of Finance/

Treasury

On the Governance of Financial Stability Institutions

Implications of systemic risks on rules and institutions

Systemic risks

Rules

Institutions

Risk-based regulation

Broad perimeter

Financial Safety Net

Financial Stability Framework

Centralized Regulation

Ownership/stockholding of non-financial entities

Corporate governance

Regulatory treatment of public entities

Exposure to common and correlated risks

Interconnectedness (players and markets)

Financial and real sector conglomerates/

cross border

New kinds of risks as markets develop

Regulatory arbitrage across entities with different licenses

On the Governance of Financial Stability Institutions

Domestic Markets and Financial Stability in Emerging Economies

Mario BergaraCentral Bank of Uruguay

19th Dubrovnik Economic ConferenceJune 13, 2013