Financial Sector Assessment

Development with Stability: The Role of Sequencing2

Long-term economic growth hinges on sound financial institutions and deep financial markets to mobilize savings and allocate resources. The liberalization of financial insti­tutions, markets, and cross-border capital flows that are aimed at deepening financial intermediation and capital markets, however, increases risks that often result in financial distress and crisis. As new institutions, instruments, and markets emerge, risks evolve in complexity and magnitude.

The goal of the orderly sequencing of financial sector reform is to safeguard monetary and financial stability during financial liberalization and financial sector development. Strategies to develop local financial markets and intuitions must revolve around mitigat­ing risks injected in the financial system as markets develop and become more sophisti­cated. Risks consist both of financial risks faced by financial intermediaries and market participants, and of macroeconomic risks that may be triggered by financial liberalization (e. g., loss of monetary control or excessive interest rate volatility following liberalization measures). Thus, market development and liberalization measures would need to be bol­stered by parallel measures to mitigate both financial and macroeconomic risks. Financial development policies should also be sequenced to allow adequate buildup of risk manage­ment capacity and its associated infrastructure.

The different markets (e. g., money, exchange, bond, equity, and derivatives) and various financial products and services (e. g., credit to target groups and financial services to the poor) that need to be developed may be hierarchically ordered according to the types and complexity of risks to be managed when particular markets or products develop and expand, and on the scope of institutional preparations needed for good governance. This ordering helps set broad priorities among various financial sector segments that need further development, and it constitutes a key preparatory step in sequencing. The top row of figure 12.1 illustrates this key step by presenting various goals for the devel­opment of market and financial services in a hierarchical order (see section 12.4 for a further discussion). This hierarchy primarily reflects the complexity of risks that need to be addressed and other short - and medium-term priorities that are country specific. In particular, building and strengthening short-term money markets and risk management

Figure 12.1. Financial Development: Stylized Sequencing of Reforms

Types of measures

Market and product development

1. Entry, instrument design, primary issuance, and access policies

2. Trading and settlement infrastructure

Risk mitigation

3. Prudential supervision and market conduct oversight

4. Risk controls in the payment system

5. Macroprudential surveillance and macro­policies to manage volatility and systemic risks

Financial system infrastructure

6. Accounting and disclosure standards

7. Insolvency regime and property rights

8. Internal information systems, transparency, and governance

Financial institutions restructuring and recapitalization

Capital account liberalization

9. Capital inflows and instruments and sectors

10. Capital outflows by instruments and sectors

Note: Arrows represent the listing measures under each theme.

Source: Karacadag, Sundararajan, and Elliott (2003).

in such markets can set the stage and can facilitate the development and effective risk management—both financial and macroeconomic—of longer-term and more-risky secu­rities. Measures to develop government bond markets, such as promoting primary dealers to provide market-making services, are generally facilitated by the availability of active money markets that are based on treasury bills or other instruments. The development of government bond markets and of a structure of risk-free yields provides the benchmark
for pricing corporate bonds and other more-risky securities and derivative products, thus facilitating risk management. Measures to strengthen the access of target groups such as rural areas and small firms to financial services are medium-term goals that follow a strengthening of the basic banking, money, and government securities markets that help manage macroeconomic risks.

Domestic and external financial reforms thus need to be pursued in a manner that builds the capacity of regulators and financial institutions to monitor and manage the risks associated with a wide range of financial markets, permissible financial transactions, investable instruments, and loanable funds, particularly the following:

• Capital market development-cum-financial stability hinges on establishing the institutional infrastructure for controlling both macroeconomic and financial risks. Macroeconomic risk management requires effective instruments and institutions for monetary and exchange policy implementation, including well-functioning money, exchange, and government debt markets (Ishii and Habermeier, 2002). Financial risk management depends on high standards in corporate governance, accounting, and disclosure, and in prudential regulation and supervision. Those institutional reforms are critical to fostering an environment in which capital mar­kets can grow without undermining financial stability.

• Developing sound financial institutions is a critical component of building capital markets and financial risk-management capacity. Both bank and non-bank finan­cial institutions are the key counterparties in financial markets. They often create and transmit risks. As such, establishing good governance structures—including effective internal controls and risk-management systems—in financial institutions is among the most critical of market reforms.

• Reforms in financial system infrastructure—including the insolvency regime, creditor rights, and accounting and disclosure—and prudential regulation and supervision should start early in the process of market development, given the time needed to implement the reforms and their importance to financial institution restructuring and good corporate governance.

• Capital account liberalization and domestic financial reforms should be approached in an integrated manner (Johnston and Sundararajan 1999). Capital account liberalization by instruments and sectors should be sequenced in a manner that reinforces domestic financial liberalization and allows for institutional capacity building to manage the additional risks, as further explained in the next section.