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Edited by Masahiro Kawai and Eswar S. Prasad

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New Paradigms for Financial Regulation

BROOKINGS INSTITUTION PRESS

Contents

Preface.....................................................................................................................................................................vii1 Introduction and Overview Masahiro Kawai and Eswar S. Prasad.............................................................................................................12 The Dodd-Frank Act and Basel III: Intentions, Unintended Consequences, and Lessons for Emerging Markets Viral V. Acharya.................................................133 Global Financial Regulations and the Asian Financial System: Lessons from the Financial Crisis Yoshinori Shimizu.........................................................454 The Asian Financial System: Development and Challenges Cyn-Young Park....................................................................................................775 Financial Globalization in Emerging Countries: Diversification versus Offshoring Francisco Ceballos, Tatiana Didier, and Sergio L. Schmukler.............................1106 Strengthening Macroeconomic Frameworks: The Indian Experience Subir Gokarn...............................................................................................1397 The Macroprudential Policy Framework from an Asian Perspective Kiyohiko G. Nishimura.....................................................................................1698 Emergence in the Postcrisis World: Widening Asymmetries between Advanced and Emerging Economies Mehmet Yörükoglu...............................................1919 The Impact of Changes in the Global Financial Regulatory Landscape on Emerging Markets Tarisa Watanagase.................................................................22510 International Financial Reforms: Capital Standards, Resolution Regimes, and Supervisory Colleges and Their Effect on Emerging Markets Duncan Alford.....................244Contributors................................................................................................................................................................279Index.......................................................................................................................................................................281

Chapter One

MASAHIRO KAWAI AND ESWAR S. PRASAD

The global financial crisis has led to a sweeping reevaluation of frameworks for financial market regulation and macroeconomic policies. Some progress has been made on strengthening these frameworks, both at the national and international levels, but numerous challenges lie ahead in terms of developing an analytical framework to guide these changes in a manner that promotes financial stability. This book provides a stock-taking exercise for these issues and evaluates recent developments from an emerging markets perspective.

The main objective of this book is to develop analytical frameworks and policy prescriptions for emerging markets for balancing the goals of financial development and broader financial inclusion, with the imperative of strengthening macroeconomic and financial stability in these economies. The book starts with two chapters that provide an overview of the global regulatory landscape and discusses these from the perspective of Asian emerging markets. The next set of chapters discusses how to promote financial development and inclusion in these emerging markets in a manner that takes account of regulatory concerns and constraints. The third set of chapters evaluates different approaches to strengthening macroeconomic frameworks in a manner that promotes financial stability. Finally, the book turns to issues related to cross-border regulatory coordination, which are becoming increasingly important as financial institutions operate freely across national borders and as capital flows serve as a channel for the rapid international transmission of financial shocks.

Part I. The Evolving Global Regulatory Landscape: Implications for Emerging Markets

Chapter 2, by Viral Acharya, is titled "The Dodd-Frank Act and Basel III: Intentions, Unintended Consequences, and Lessons for Emerging Markets." This chapter attempts to explain the changes to financial sector reforms under the Dodd-Frank Act in the United States and Basel III requirements globally, their unintended consequences, and the risks to fast-growing nations such as India from the adjustment by the global financial sector to these changes. The chapter also provides some broader lessons for India concerning financial sector reforms, government involvement in the financial sector, possible macroprudential safeguards against spillover risks from the global economy, and finally, management of government debt and fiscal conditions.

Acharya argues that the Dodd-Frank Act has a number of shortcomings. These include lack of adequate attention to the distortive role played by government guarantees to the financial sector, an ill-conceived resolution authority that is likely to contribute to substantial uncertainty at the time of the next crisis, and inadequate regulation of shadow banking. Turning to Basel III, Acharya argues that, like its predecessors, it is fundamentally flawed as a way of designing macroprudential regulation of the financial sector. He argues that the Basel capital requirements employ static risk weights, fail to recognize that risk weights alter the incentives of the financial sector exposed to different asset classes, ignore correlated or concentrated exposures of the financial sector to apparently safe asset classes, and do not employ direct firm-level or asset-level leverage restrictions. He acknowledges that Dodd-Frank has several redeeming features, including requirements of stress-test-based macroprudential regulation and explicit investigation of systemic risk in designating some financial firms as systemically important.

Acharya contends that emerging markets like India should resist the call for a blind adherence to Basel III and persist with the approach adopted by the Reserve Bank of India, including asset-level leverage restrictions and a dynamic sector risk-weight adjustment approach. Indeed, these asset-level and dynamic approaches, which are popular in India and some other Asian countries, would be useful for the Basel Committee and other Western regulators to consider in future financial reforms. The author makes the case for the following financial sector reforms in India:

—Institute a fee for government guarantees to the banking sector (especially the explicitly guaranteed, state-owned sector).

—Undertake a fully macroprudential view of its financial sector regulation (covering not just banks but also shadow banks).

—Strive for a consensus among fast-growing emerging markets as well as in the G-20 for principles guiding systemic risk containment in the financial sector, which in turn can limit global spillover risks (such as the eurozone debt crisis).

—Manage the government debt level and fiscal deficit in a countercyclical manner, while also deepening credit and fixed-income markets.

The chapter by Yoshinori Shimizu, titled "Global Financial Regulations and the Asian Financial System: Lessons from the Financial Crisis," draws three lessons from the global financial crisis and proposes some directions for global regulatory reform. The three lessons identified in the chapter are as...