Global Shock Risks Asian Financial Reform

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Global Shock, Risks, and Asian FinancialReform


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Global Shock, Risks,and Asian Financial

Reform

Edited by

Iwan J. AzisAsian Development Bank and Cornell University, USA

Hyun Song Shin

Professor of Economics, Princeton University, USA

CO-PUBLICATION OF THE ASIAN DEVELOPMENT BANKAND EDWARD ELGAR PUBLISHING

Edward ElgarCheltenham, UK Northampton, MA, USA


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Asian Development Bank 2014

All rights reserved. No part of this publication may be reproduced, stored in aretrieval system or transmitted in any form or by any means, electronic, mechanical

or photocopying, recording, or otherwise without the prior permission of thepublisher.

Published byEdward Elgar Publishing Limited Edward Elgar Publishing, Inc.The Lypiatts William Pratt House15 Lansdown Road 9 Dewey CourtCheltenham NorthamptonGlos GL50 2JA Massachusetts 01060UK USA

The views expressed in this book are those of the authors and do not necessarilyreflect the views and policies of the Asian Development Bank (ADB), its Board ofGovernors or the governments they represent.

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Typeset by Servis Filmsetting Ltd, Stockport, CheshirePrinted and bound in Great Britain by T.J. International Ltd, Padstow


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v

Contents

List of contributors ixList of abbreviations xi

PART I OVERVIEW AND SUMMARY

1 Overview and summary 3 Iwan J. Azis and Hyun Song Shin

PART II MACRO-PRUDENTIAL SUPERVISORY SYSTEMAND DEVELOPMENT IMPACT

Introduction 15Hyun Song Shin

2 Monetary aggregates and procyclicality of the financialsystem: an Asian perspective 22

Joon-Ho Hahm, Hyun Song Shin and Kwanho Shin

3 Non-core bank liabilities and vulnerability to crisis:implications for Asia 74

Joon-Ho Hahm, Hyun Song Shin and Kwanho Shin

4 Monetary aggregates and global liquidity: evidence fromindividual firm data from Asia 102

Hyun Song Shin and Laura Yi Zhao

5 Economy-wide vulnerability in Asia: flow-of-fund analysis 150 Iwan J. Azis and Damaris Yarcia

PART III ISSUES AND CHALLENGES ON THE LEGALAND INSTITUTIONAL FRAMEWORK FOREMERGING ASIA

Introduction 197

Fariborz Moshirian


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vi Global shock, risks, and Asian financial reform

6 Addressing systemic risk in East Asia: financial regulatorydesign 204

Rolf H. Weber, Douglas W. Arner, Evan C. Gibson and

Simone Baumann

7 Financial innovation and development in East Asia: balancingrisks and opportunities 246

Ross P. Buckley, Douglas W. Arner and Michael Panton

8 Implications of global financial and regulatory policies onsystemic risk in Asia 284

Fariborz Moshirian

PART IV FINANCIAL INTEGRATION ANDCOOPERATION TO SUPPORT FINANCIALSTABILITY

Introduction 335Noritaka Akamatsu

9 Equity home bias, financial integration, and regulatoryreforms: implications for emerging Asia 347

Cyn-Young Park and Rogelio V. Mercado, Jr

10 Regional financial arrangements: lessons from the Eurozonecrisis for East Asia 377

Emilios Avgouleas, Douglas W. Arner and Uzma Ashraf

11 The role of deposit insurance in financial stability: issues andoptions in the ASEAN13 416

A. Michael Andrews

12 Effective resolution regimes for financial institutions in

ASEAN13 464 A. Michael Andrews

13 Capital structure and the issuance of corporate bonds inemerging Asia 510

Paul Mizen, Frank Packer, Eli Remolona and Serafeim Tsoukas

PART V FINANCIAL SUPERVISION AND DEVELOPMENTCHALLENGES IN ASIA

Introduction 543Ramesh Subramaniam


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Contents vii

14 Financial monitoring in the new ASEAN-5 countries 554 Se Hee Lim and Noel G. Reyes

15 Financial inclusion and regulatory implications 600 Qifeng Zhang and Josephine B. Valle-Sison

16 Innovative financing models for SMEs and the regulatoryimplications 628

Shigehiro Shinozaki

17 Global financial regulatory trends and challenges for thedevelopment of the insurance and pensions sector in theAsia-Pacific region 676

Arup Chatterjee18 Impact of the global financial crisis on trade finance in Asia

and the cooperative effort to respond 701 Steven Beck

Index 717


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ix

Contributors

Noritaka Akamatsu, Deputy Head of the Office of Regional EconomicIntegration, ADB.

A. Michael Andrews, A. Michael Andrews and Associates Limited.

Douglas W. Arner, Asian Institute of International Financial Law, Faculty

of Law, University of Hong Kong, China.

Uzma Ashraf, Asian Institute of International Financial Law, Faculty ofLaw, University of Hong Kong, China.

Emilios Avgouleas, University of Edinburgh, UK.

Iwan J. Azis, ADB and Cornell University, USA.

Simone Baumann, University of Zurich, Switzerland.

Steven Beck, Head of Trade Finance, Private Sector Operation, ADB.

Ross P. Buckley, CIFR King & Wood Mallesons Professor of InternationalFinance Law, University of New South Wales, Australia.

Arup Chatterjee, Principal Financial Sector Specialist, ADB.

Evan C. Gibson, Asian Institute of International Financial Law, Faculty ofLaw, University of Hong Kong, China.

Joon-Ho Hahm, Professor of International Economics and Finance at theGraduate School of International Studies, Yonsei University.

Se Hee Lim, Financial Supervisory Service, Korea.

Rogelio V. Mercado, Jr, Economics Research Department, ADB.

Paul Mizen, University of Nottingham, UK.

Fariborz Moshirian, Institute of Global Finance, University of New SouthWales, Sydney, Australia.

Frank Packer, Bank for International Settlements.

Michael Panton, Asian Institute of International Financial Law, Facultyof Law, University of Hong Kong, China.


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Cyn-Young Park, Assistant Chief Economist, Economics and ResearchDepartment, ADB.

Eli Remolona, Bank for International Settlements.Noel G. Reyes, Office of Regional Economic Integration, ADB.

Hyun Song Shin, Professor of Economics, Princeton University, USA.

Kwanho Shin, Professor of Economics at Korea University.

Shigehiro Shinozaki, Office of Regional Economic Integration, ADB.

Ramesh Subramaniam, Deputy Director General, Southeast AsiaDepartment, ADB.

Serafeim Tsoukas, University of Glasgow, UK.

Josephine B. Valle-Sison, Office of Regional Economic Integration, ADB.

Rolf H. Weber, University of Zurich, Switzerland.

Damaris Yarcia, Consultant, Department of Social Welfare andDevelopment, Government of the Philippines; graduate student, Schoolof Statistics, University of the Philippines Diliman.

Qifeng Zhang, Office of Regional Economic Integration, ADB.

Laura Yi Zhao, Office of Regional Economic Integration, ADB.


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xi

Abbreviations

93 SNA 1993 System of National AccountsABF Asian Bond FundABF asset-based financeABF2 Asian Bond Fund 2ABIF ASEAN Banking Integration Framework

ABL asset-based lendingABMF ASEAN13 Bond Market ForumABMI Asian Bond Market InitiativeABMIF Asian Multicurrency Bond Issuance FacilityABS asset-backed securitiesACC Asian Consultative CommitteeACE Access, Certainty, EfficiencyACMF ASEAN Capital Markets ForumACU Asian currency unit

ADB Asian Development BankADF Asian Development FundADF augmented Dickey-FullerAEC ASEAN Economic CommunityAFAS ASEAN Framework Agreement on ServicesAFC Asian financial crisisAFSD Asian Financial Stability DialogueAIG American Insurance GroupAIGFP American Insurance Group Financial Products

AIM Alternative Investment MarketAMBD Autoriti Monetari Brunei DarussalamAMBIF Asian Multicurrency Bond Issuance FrameworkAML anti-money launderingAML-CFT anti-money laundering and combating the financing of

terrorismAMRO ASEAN13 Macroeconomic Research OfficeAPEC Asia-Pacific Economic Cooperation ConferenceAPRA Australian Prudential Regulatory Agency

ASEAN 5 Indonesia, Malaysia, the Philippines, Thailand, and VietNam


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xii Global shock, risks, and Asian financial reform

ASEAN Association of Southeast Asian NationsASEAN13 ASEAN plus the PRC, Japan, and the Republic of

Korea

ASEAN-4 Indonesia, Malaysia, the Philippines, and ThailandATM automated teller machineAVC asset value correlationBasel III Basel Capital AccordBCBS Basel Committee on Banking SupervisionBCMLV Brunei Darussalam, Cambodia, Myanmar, the Lao

Peoples Democratic Republic and Viet NamBIS Bank for International SettlementsBN Brunei Darussalam

BND Brunei Darussalam dollarBNM Bank Negara MalaysiaBOK Bank of KoreaBOL Bank of LaoBPS Badan Pusat Statistik (Central Bureau of Statistics)BSE Bombay Stock ExchangeBSP Bankgo Sentral ng PilipinasBSP Bankgo Sentral ng PilipinasCAMEL capital adequacy, asset quality, management quality,

earnings, and liquidityCAR capital adequacy ratioCBM Central Bank of MyanmarCBOE Chicago Board Options ExchangeCCF credit conversion factorCCP central counterpartiesCCT conditional cash transferCD certificate of depositCDO collateralized debt obligation

CDS credit default swapCEBS Committee of European Banking SupervisorsCEIOPS Committee of European Insurance and Occupational

Pensions SupervisorsCES constant elasticity of substitutionCESR Committee of European Securities RegulatorsCET constant elasticity of transformationCFT combating the financing of terrorismCGAP Consultative Group to Assist the PoorCGE computable general equilibriumCGIF Credit Guarantee and Investment FacilityCVIRC China Insurance Regulatory Commission


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Abbreviations xiii

CMG Crisis Management GroupCMI Chiang Mai InitiativeCMIM Chiang Mai Initiative Multilateralization

CMIM-PL CMIM Precautionary LineCML Capital Markets LawCN China PRCCNY Chinese yuanCoCos convertible contingent capitalComFrame Common Framework for the Supervision of

Internationally Active Insurance GroupsCP commercial paperCPA certified public accountant

CPIS Coordinated Portfolio Investment SurveyCPSS Committee on Payment and Settlement SystemsCSIF Cross-border Settlement Infrastructure ForumCSRC China Securities Regulatory CommissionDATC Debt and Asset Trading CompanyDBN De Nederlandsche BankDCC dynamic conditional correctionDDR deposit reserve ratioDFID Department for International Development

DGS deposit guarantee schemeDICJ Deposit Insurance Corporation of JapanDRR deposit reserve ratioD-SIFI domestic systematically important financial institutionDTI debt to incomeDVI Deposit Insurance of Viet NamEBA European Banking AuthorityEBU European Banking UnionECA export credit agency

ECB European Central BankEDP excessive deficit procedureEEC European Economic CommunityEIOPA European Insurance and Occupational Pensions

AuthorityEME emerging market economyEMEAP Executives Meeting of East Asia Pacific Central BanksEMS European Monetary SystemEMU European Monetary UnionERM enterprise risk managementERM II Exchange Rate Mechanism IIERPD Economic Review and Policy Dialogue


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ESA European Supervisory AuthorityESCB European System of Central BanksESFS European System of Financial Supervision

ESM European Stability MechanismESMA European Securities and Markets AuthorityESRB European Systemic Risk BoardETP Electronic Trading PlatformEU European UnionFAS Financial Access SurveyFASB Financial Accounting Standards BoardFATF Financial Action Task ForceFCI Factors Chain International

FCL flexible credit lineFCY foreign currencyFDI foreign direct investmentFDIC Federal Deposit Insurance CorporationFed Federal ReserveFINMA Swiss Financial Market Supervisory AuthorityFINMASA Swiss Financial Market Supervisory ActFOF flow of fundsFPC Financial Policy Committee

FSA Financial Services AuthorityFSAP Financial Sector Assessment ProgramFSAP Financial Services Action PlanFSB Financial Stability BoardFSC Financial Services CommissionFSF Financial Stability ForumFSS Financial Supervisory ServiceFTAAP Free Trade Area of the Asia-PacificFX foreign exchange

G20/G-20 Group of 20GAAP generally accepted accounting principlesGARCH generalized autoregressive conditional heteroskedasticityGDP gross domestic productGEM Growth Enterprise MarketGFC global financial crisisGISC Global Industry Classification StandardGlobal Findex Global Financial Inclusion DatabaseGPFI Global Partnership for Financial InclusionGRIF general rule of international factoringG-SIFI global systematically important financial institutionG-SII global systemically important insurer


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Abbreviations xv

HKMA Hong Kong Monetary AuthorityHLA higher loss absorbencyHP Hodrick-Prescott

HRE Hypo Real EstateHSX Hanoi Stock ExchangeIADI International Association of Deposit InsurersIAI Initiative for ASEAN IntegrationIAIG internationally active insurance groupIAIS International Association of Insurance SupervisorsIAS international accounting standardsIASB International Accounting Standards BoardIBF international banking facility

IBRA Indonesian Bank Restructuring AgencyICAPM International Capital Asset Pricing ModelICC International Chamber of CommerceICP Insurance Core PrincipleICRG International Co-operation Review GroupICT information communications technologyID identityID IndonesiaIDIC Indonesia Deposit Insurance Corporation

IDR Indonesian rupiahIDS Information Disclosure SystemIDSA International Derivative and Swap AssociationIFC International Finance CorporationIFG International Factors GroupIFRS International Financial Reporting StandardsIFS International Financial StatisticsIIP International Investment PositionIIX Impact Investment Exchange Asia

IMF International Monetary FundINFE International Network on Financial EducationINVA investment over total assetsIOSCO International Organization of Securities CommissionsIPO initial public offeringIRDA Insurance Regulatory and Development AuthorityIT information technologyJBIC Japan Bank for International CooperationJICA Japan International Cooperation AgencyJSDA Japan Securities Dealers AssociationKOFIA Korea Financial Investment AssociationKONEX Korea New Exchange


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xvi Global shock, risks, and Asian financial reform

KOSDAQ Korean Securities Dealers Automated QuotationsKRW Korean wonKRX Korea Exchange

KYC know your client/customerLAK Laotian kipL/C letters of creditLao PDR Lao Peoples Democratic RepublicLCR liquidity coverage ratioLCY local currencyLOLR lender of last resortLSX Lao Securities ExchangeLTCM Long Term Capital Management

LTV loan to valuemai market for alternative investmentMAS Monetary Authority of SingaporeMCR minimum capital requirementMEB Myanmar Economic BankMEF Ministry of Economy and FinanceMES marginal expected shortfallMESDAQ Malaysian Exchange of Securities Dealing and

Automated Quotation

MetLife Metropolitan Life Insurance CompanyMFB microfinance banksMFI microfinance institutionMiFID Markets in Financial Instruments DirectiveML maximum likelihoodMNO mobile network operatorMOF Ministry of FinanceMOU Memorandum of UnderstandingMPI macro-prudential indicators

MPS macro-prudential policy and surveillanceMSEC Myanmar Securities Exchange Center Company LimitedMSMEs micro, small, and medium-sized enterprisesMY MalaysiaNAFMII National Association of Financial Market Institutional

InvestorsNBC National Bank of CambodiaNCD negotiable certificate of depositNDF non-deliverable forwardNBFI non-bank financial institutionNDRC National Development and Reform CommissionNGO non-governmental organization


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Abbreviations xvii

NIEs newly industrialized economiesNPL non-performing loanNPV net present value

NSE National Stock ExchangeNSFR net stable funding ratioNYU New York UniversityOECD Organisation for Economic Co-operation and

DevelopmentOFID OPEC Fund for International DevelopmentOLS ordinary least squaresOMT outright monetary transactionOPEC Organization of Petroleum-Exporting Countries

OREI Office of Regional Economic IntegrationORSA Own Risk and Solvency AssessmentOTC over the counterPBOC Peoples Bank of ChinaPCL precautionary credit linePCR prescribed capital requirementPDIC Philippines Deposit Insurance CorporationPDR Peoples Democratic RepublicPPP publicprivate partnership

PRA Prudential Regulatory AuthorityPRC Peoples Republic of ChinaQ3 quarter 3Q4 quarter 4QAB Qualified ASEAN BankQE quantitative easingQIB qualified institutional buyerRAF risk appetite frameworkRBA Reserve Bank of Australia

RBI Reserve Bank of IndiaRCC rural credit cooperativeRCEP Regional Comprehensive Economic PartnershipRDB Regional Development Bankrepo overnight repurchase agreementRMB renminbiRP repurchase agreementRRP recovery and resolution planRSI Regional Settlement IntermediaryR-SIFI regional systematically important financial institutionRWA risk-weighted assetRYM Malaysian ringgit


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xviii Global shock, risks, and Asian financial reform

S&P 500 Standard and Poors 500 Stock IndexSBV State Bank of Viet NamSCF supply chain finance

SCR solvency capital requirementSEACEN Southeast Asian Central BanksSEC Securities and Exchange CommissionSECC Securities and Exchange Commission of CambodiaSECO Securities and Exchange Commission OfficeSES systemic expected shortfallSET Securities Exchange of ThailandSGD Singapore dollarSGP Stability and Growth Pact

SIB systemically important bankSIFI systematically important financial institutionSMEs small and medium-sized enterprisesSNB Swiss National BankSOE state-owned enterpriseSRISK systemic riskSRM single resolution mechanismSRO self-regulatory organizationSSC State Securities Commission

SSM single supervisory mechanismSZSE Shenzhen Stock ExchangeTARP Troubled Asset Relief ProgramTBTF too big to failTFEU Treaty on the Functioning of the European UnionTFP Trade Finance ProgramTH ThailandTHB Thai bahtTRACE Trade Reporting and Compliance Engine

UK United KingdomUN United NationsUS United States of AmericaUSD United States of America dollarVAMC Viet Nam Asset Management CompanyVAS Viet Nam accounting standardsVIX Volatility IndexVN Viet NamVND Vietnamese dongVS vertical specializationWMP wealth management productWTO World Trade Organization


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PART I

Overview and Summary


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1. Overview and summaryIwan J. Azis and Hyun Song Shin

The growth of financial markets has clearly outpaced the developmentof financial market regulations. With growing complexity in the worldof finance and the resultant higher frequency of financial crises, all eyes

have shifted toward the current inadequacy of financial regulation. Withfinancial innovation and securitization becoming more popular, inter-connectedness in the financial system is at its height, both for intra- andextra-sovereign jurisdictions. Geographical boundaries have less relevancefor financial flows than they do for trade in goods. During good eco-nomic times in the past, supported by financial innovation, financial andnon-financial institutions alike were eager to participate in the expandingfinancial sector with its promise of high returns. The risk compression waswidespread. Seen from this perspective, the 200809 global financial crisis

(GFC) that occurred in the US, and the subsequent crisis in the Eurozone,should not be too surprising. Meanwhile, the policy response has beenunprecedented. And surely it affects Asia.

The book is about what this episode means for Asias financial sectorand its stability, and what will be the implications for the regions financialregulation.

Fluctuations in US and Eurozone interest rates since 2000 could nothave been more pronounced. Responding to the 2000 recession and theevents of 11 September 2001, the US Federal Funds rate fell precipitously

from over 6 percent in 2001 to a mere 1 percent by summer of 2003.Over the same period, the European Central Bank (ECB) rate droppedfrom over 4 percent to 2 percent. Fears of asset bubbles subsequentlyled to interest rate increases in the US and Europe. By late 2007, on theeve of recession and the subprime crisis, rates had doubled in Europeand increased more than fivefold in the US. As the recession began inDecember 2007, the Federal Reserve drastically shifted gears again, lower-ing interest rates steadily from more than 5 percent to 2 percent by mid-2008. The subsequent collapse of Lehman Brothers in September forced

the Federal Reserve to be even more aggressive in pushing down rates, withthe Federal Funds rate reaching 0.25 percent by the end of 2008, which


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4 Global shock, risks, and Asian financial reform

is where it remains at the time of writing. The fall of interest rates in theEurozone was not much less dramatic, with a steady decline from over 4percent in 2007 to 1 percent shortly after the Lehman crisis, to 0.5 percent

in mid-2013, and 0.25 percent at the time of writing.Amid financial globalization, such sharp swings in interest rates in

developed economies have generated waves of capital flows to developingeconomies, including in Asia which has already held considerable excesssavings since the aftermath of the 199798 Asian financial crisis. Whatare the impacts of such flows in terms of the risks of financial instability,and to what extent do the excess savings affect the investment decisions ofagents? These fundamental questions are dealt with in Part II.

Much of the flow of capital into Asia has been intermediated by the

banking sector as evidenced by the increasing share of banks non-coreliabilities, which also reflects changes in the wholesale funding market.This poses the risk of procyclicality and it also reduces the sensitivity ofnon-core liabilities to output changes and monetary policy. The resultingfinancial cycle is not in synchronization with the business cycle, makingmonetary policy alone insufficient to deal with the procyclicality andfinancial instability caused by such bank-led flows. This is the reason whymacro-prudential policy needs to complement standard macroeconomicpolicy.

Given changes in global financial conditions, the importance of the non-core liability ratio as part of an early warning system cannot be overem-phasized. The power of this ratio to predict financial and currency crises,under different levels of capital market openness, is shown in Chapter 3,which suggests that macro-prudential policy must take into account thecomplex relationship between banks non- core liabilities and capital flows.Any efforts to further liberalize the financial sector also must account forsuch a relationship.

However, not all countries in Asia have a liberalized system of capital

flows. Those economies that still control flows can insulate themselvesfrom risk. At least that is what many would expect. Yet, even in a rela-tively closed banking system, non-financial firms can take up the role offinancial intermediation by depositing external funds and their proceedsin the domestic banking system, which in effect influences domestic creditconditions. Thus, the risks of procyclicality remain in place even in a closedbanking system. In such circumstances, decomposing M2 into core andnon-core liabilities is more useful for the purpose of gauging financial sta-bility. By using the case of the PRC and utilizing firm-level data, this issueis analyzed in detail in Chapter 4.

With the emergence of excess savings after the 199798 Asian financialcrisis, massive inflows of capital also meant additional liquidity in the


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Overview and summary 5

regions economy. The cost of capital fell markedly as a result. This envi-ronment has changed the investment decisions and behavior of banks,firms, and households, as they lean toward more risky spending and

prefer investing in financial assets. The macro-financial implications andhow they affect the real sector, including socioeconomic conditions, arediscussed in the last chapter of Part II. It is shown that the compositionof excess savings differs across countries in the region, and that the visibletrends are also unequal. The rise of corporate savings is notable, largelycaused by improved current accounts and growing per capita incomeacross the region.

Prior to the GFC, a growing share of capital inflows was intermediatedthrough the banking sector, and hence was labeled bank-led flows. After

the GFC, the flows going through debt or bond markets became signifi-cant, and hence were labeled debt-led flows. In addition to the exchangerate pressure exerted by capital inflows, these two types of flows are par-ticularly volatile. As bank-led flows lead to rapid growth in credit, espe-cially in the property and consumer goods sectors, and also raise bankspreferences for risky financial assets, the risk of procyclicality can be high.The reaction to the Federal Reserves announcement in mid-2013 that itwas considering tapering its quantitative easing measures also shows thatthe reversals of debt-led flows can easily cause fluctuations in exchange

rates and rattle bond markets. This can undermine long- term financing incapital markets. Clearly, policymakers and regulators are faced with a veryserious challenge.

The rise of agents preference for financial assets is largely driven by thelure of high returns in the fast-growing financial sector, the perception oflow risk compared with investing in the real sector (owing to numerousdifficulties associated with a less-than-favorable business climate), and thegreater number of financial instruments created through financial liberali-zation and innovation. Yet, the fact that in most countries only a tiny share

of the population has access to the financial sector may have exacerbatedalready skewed income and asset inequality. This phenomenon is high-lighted in the last section of Part II by using an empirical case study basedon an economy-wide model where a large portion of the increased incomeof financial asset holders (mostly the urban rich) is generated from assetreturns, leaving those with no financial assets in a relatively disadvantagedposition. The development impact of investing the excess savings in finan-cial assets rather than in real sector investment is also apparent in the labormarket. To the extent that the job-creating capacity of financial investmentis smaller than that of real sector investment, this contributes to fallingemployment elasticities observed throughout Asia.

The analysis in Part II shows that the risks of procyclicality associated


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with increased non-core liabilities through bank-led flows and volatility incapital markets are not only manifest in macro-financial vulnerability, butalso in development terms through rising income inequality and unem-

ployment. Based on this premise, therefore, if appropriately designed andeffectively enforced, the proposed macro-prudential policy may providebenefits beyond just ensuring financial stability.

The resulting effect of the procyclicality risks can also interrupt busi-ness and financial cycles, which may reduce the effectiveness of standardmacroeconomic policy, as discussed in detail in Part III. More seriously,given the dominant role of banks, including their influence over capitalmarkets in the region, the risks can be systemic. This is where the rules andstandards play an essential function, especially in relation to systemati-

cally important financial institutions (SIFIs). The supervision of SIFIs whether domestic (D-SIFIs), regional (R-SIFIs), or global (G-SIFIs) iscritical as their failing can result in severe financial instability impacting anations financial system and economy, and further spreading into regionaland global financial systems. Although the economies of emerging Asiaare typically characterized by relatively large D-SIFIs with only a handfulof G-SIFIs, hence international financial regulatory standards may notcurrently be a priority, increasingly more D-SIFIs in the region have trans-formed into R-SIFIs. As this will increase the amount of cross-border

operations, the regulatory design and standards must eventually addressissues surrounding how to supervise the cross-border operations of SIFIs.This topic is discussed in Chapter 6. It is also argued in this section thata regulatory structure must vary according to the nature and size of itsfinancial sector, its domestic and international importance, and the skillsand resources of regulators and the particular government.

To the extent that financial liberalization offers benefits but also carriesrisks of financial crisis, the discussions in Chapter 7 put the whole conceptof financial liberalization and innovation into a more balanced perspec-

tive, whereby all the potential risks are matched with the benefits andopportunities of liberalization, including opportunities associated withdevelopment-related matters (for example, mortgage markets, small andmedium-sized enterprises SMEs finance, non-bank finance, tradefinance, and mobile financial services). By focusing on legal and institu-tional frameworks, this section elaborates on various issues and challengesin terms of how financial liberalization can maximize the benefits andminimize the risks of crisis.

Understanding the importance of systemic risk is important, but meas-uring it is another issue. What elements and factors need to be incorporatedin the measure of systemic risks? To the extent that banks operations arebecoming more interconnected, especially between large and medium-sized


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banks, Chapter 8 explores alternative measures of systemic risk by usingthe examples of some ASEAN13 countries, as well as India, in compari-son with the situations in Europe and the US.1It is argued that although

only a handful of G-SIFIs are operating in Asia, some of the large regionalbanks could pose potential risks to overall financial stability in the region.

Integration and cooperation in support of financial stability is discussedin Part IV. The current dominance of D-SIFIs in Asia resembles thesituation in the regions capital markets. In general, Asian investors havea strong home bias and, to a lesser extent, a global bias, while lacking aregional bias. Yet, as discussed in Chapter 9, home bias is inefficient asinvestors concentrate on domestic assets, reducing portfolio diversifica-tion, the efficient allocation of capital, and risk sharing. To the extent that

increased integration and home bias are interlinked, the type and qualityof financial reform to create greater transparency and lower informationasymmetry to promote integration can also influence the degree of homebias. Whether they will result in increased cross-border flows within Asiamore than increased flows between Asia and the rest of the world shouldnot be a concern. To reduce the level of home bias, the focus should be onremoving the unnecessary obstacles that remain.

While opening up financial markets offers benefits, as discussed inChapter 10, the risks involved are not small. The bitter experience of the

199798 Asian financial crisis still lingers. The misplaced policy responseadvocated by the IMF had consequences that led ASEAN13 countries toset-up a new regional financial arrangement. Known as the Chiang MaiInitiative (CMI), the arrangement started with a series of bilateral swapsthat were subsequently combined and multilateralized (henceforth knownas the CMIM). Efforts were also made in the area of crisis prevention.Learning from Europes challenges in dealing with crisis in an environmentwhere integrated supranational institutions are not supported by suitableinstitutions to absorb shocks, Chapter 10 reviews the nature of regional

financial arrangement in ASEAN13 and presents some suggestions forfuture development.But the crisis management component in regional financial arrange-

ments needs to go beyond financial swaps. To limit costs to taxpayersand minimize the political fallout when financial institutions fail, and toincrease depositor confidence during a crisis, a well-designed deposit insur-ance scheme is also imperative. This is also an important part of financialsafety nets. Chapter 11 makes the argument that the old system of insur-ance is flawed in that it relies on low coverage limits and systems funded byassessments of surviving institutions. While the trade-off between securingstability through a pre-funded system and efficiency through an unfundedsystem is at the core of designing a deposit insurance system, by using


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examples from the ASEAN13, it is further argued that deposit insurancecannot be intended to absorb all the costs of a systemic crisis. However,government will always have to intervene if depositors are to be protected.

Nonetheless, since it is part of the broader role of financial safety nets, thestandard requirements for the system to be effective must be in place, suchas macroeconomic stability, a sound banking system, governance, pru-dential regulation and supervision, a strong legal framework, and a soundaccounting and disclosure regime.

More generally, an effective resolution regime is needed as part of crisismanagement. In this context, global policy development that is principles-based would be ideal, but what is more important is not the form of regula-tion rather than the practical function of the regulation. This is one of the

arguments made in Chapter 12. The best practices and the post-GFC casesin Europe, the US, and the ASEAN13 are discussed in detail, providing awide range of resolution regimes. When special resolution does not exist, itis recommended that for bank-dominated ASEAN13 countries the focusshould be on banks as opposed to other financial institutions, as they havethe most systemic significance.

Learning from the damaging effects of a double mismatch scenario thatled to the 199798 Asian financial crisis, and the fact that Asia still needsa huge amount of long-term financing for investment in infrastructure

(hard and soft), overreliance on the banking sector cannot be maintained.Financing from capital markets, especially bond markets, should play agreater role. Banks ability to obtain long-term financing has been reducedand will be curtailed even further when Basel III rules are imposed. In Asia,bond markets have developed steadily, especially in ASEAN13 countries,following the Asian financial crisis. The creation of the Asian Bond MarketInitiative (ABMI) is expected to further strengthen the regional bondmarket. While government bonds have dominated the market, corporatebonds have grown faster during the last few years. It is in this context that

the discussion in Chapter 13 focuses on factors that affect corporate bondissuance and the capital structure of corporations in emerging Asia. Usingeight countries as the sample for the period 19952007, these factors areclassified into firm and market characteristics. The results show that size,leverage, profitability, and growth prospects all influence the decision toissue for both seasoned and unseasoned issuers. Market and interest ratedifferentials also impact decisions. In the case of issuance of foreign cur-rency bonds, the following factors have a positive impact: size of firm,availability of tangible and collateral assets, short-term interest rate differ-entials, and scale of foreign participation. Meanwhile, the following factorshave a negative impact: profitability, debt-to-GDP ratio, and stock marketturnover. Overall, since the depth and liquidity of the market matter,


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efforts to improve them are recommended, including lowering withholdingtaxes and liberalizing foreign exchange swap and derivatives markets thatallow non-resident issuers to hedge against risks.

The recent phenomena of capital flows and excess savings in Asia thatinfluence the regions financial sector and related financial regulationsare important. Yet, focus should remain on their manifestation in thereal sector and the welfare of the population in general. Seemingly unre-lated issues such as inequality and the role of SMEs are in fact closelyrelated with financial sector regulation. To the extent that the majorityof participants in the financial sector are high-income and urban-basedagents, when the sector grows the gains in wealth and financial returns alsoconcentrate among these agents. As discussed in Chapter 5, this can exac-

erbate already rising inequality in Asia. In those countries where the finan-cial sector is either newly established or less developed for example, inBrunei Darussalam, Cambodia, Myanmar, the Lao Peoples DemocraticRepublic (Lao PDR), and Viet Nam, which are known collectively as theBCMLV countries the degree of concentration can be even higher. Yet,these countries and others still need further financial sector development.This is where efforts to promulgate and implement financial inclusionbecome important, along with improvements in corporate governance.

Chapter 14 in Part V emphasizes corporate governance in the BCMLV

countries by utilizing the results of a survey of monetary authorities, regu-lators, and stock exchanges. The discussion also emphasizes the importanceof sequencing financial reforms and taking into consideration the differentconditions in each country and the danger that the growth of the financialsector will outpace a countrys regulatory capabilities. The approaches topromote financial inclusion are discussed in Chapter 15. Implicit in the dis-cussion is the notion of striking a balance between expanding participationin the financial sector and ensuring financial stability. To promote financialinclusion the following should be ensured: (1) the regulatory architecture

for financial inclusion is coherent with the current legal framework; (2) anadditional layer of intra-agency and central and local government coordi-nation to cope with the variety of institutions, products, and businesses;and (3) the governance of regulatory and supervisory bodies, particularlyin preventing possible conflict of interests, is of paramount importance tosafeguarding and leveling the playing field, and ensuring the efficiency andeffectiveness of regulations.

Financing for SMEs is another important component of financial inclu-sion. Small and medium enterprises often suffer from unstable access toappropriate funding, yet such stable access is an important preconditionfor the sustainability of their operations. Chapter 16 identifies the limita-tions of traditional bank lending for SMEs from an empirical analysis and


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suggests possible regulatory responses to innovative financing modalitiesfor them from a holistic point of view.

As capital markets become even more important, it is expected that a

large pool of funds will shift toward capital markets. Two potential sourcesare pension funds and insurance companies. While the share of thesesources has indeed been growing, the level is still limited. There is ampleroom for these sources to play a greater role in the coming years. Yet, fromthe regulatory framework perspective, a lot of improvements need to bemade. Given the diversity in regulatory quality and enforcement across theregion, and with some frameworks far from being harmonized with inter-national standards, a wide range of reforms is clearly needed in the areasof solvency standards, risk assessment, and governance. As more jurisdic-

tions begin to implement the Insurance Core Principles (ICP), assessinghow best to accommodate multi-jurisdictional compliance and reportingrequirements will become a growing strategic challenge. In Chapter 17, it isargued that regulators of banks, pensions funds, and insurance companiesshould analyze the interactions of new regulations, the associated trade-offs and risks, and their consistency to avoid creating the wrong incentives.

Striking the balance between maintaining stability and growth is alwaysa primary challenge for policymakers and regulators. To the extent thatgrowth in many Asian countries is dependent on trade (both exports and

imports), the role of the financial sector and its regulation in affectingtrade cannot be overlooked. One of the critical areas of support to trade isthe provision of trade finance. During the GFC, as the interbank marketpractically ceased to function due to the reluctance of banks in advancedcountries to lend dollars and provide guarantees, banks around the world,including in Asia, had difficulty acquiring funding for trade finance. Thisseverely curtailed the regions capacity to conduct trade. Pricing for tradefinance doubled and fluctuated wildly, irrespective of the health of theregions financial sector. This contributed to the dark days in 2009 when

trade volumes fell drastically. Despite various interventions to mitigatethis problem,2the last section of Part V suggests that there are a numberof factors hampering efforts to close the trade finance gap. These includethe regulatory environment and anti- money-laundering (AML) and know-your-client (KYC) requirements that are not uniform across jurisdictionswhile also being costly amid weak banking systems that lack transparency.Clearly, more systematic interventions and reforms are needed to securethe sustainability of trade financing. Regional cooperation in this areamay also help minimize the impacts of a shock in trade financing like whathappened in 200809.

Connecting all the narratives and the analysis above, the followingstoryline emerges. While the coexistence of excess savings and massive


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capital flows in Asia during the past decade may have contributed to stronggrowth, it also elevated the risks of financial instability. These risks canlead to a financial cycle not being in sync with the business cycle, making

monetary policy insufficient to deal with procyclicality. The challengesfaced by policymakers and regulators to strike a balance between financialdevelopment and stability, or between maximizing benefits and minimizingrisks of financial liberalization, get increasingly more difficult. Facilitatingcross-border flows to reduce home bias through harmonization, and sup-porting the development of corporate bonds are examples that can help tomaximize the benefits. On the other hand, strengthening financial regula-tion and its enforcement with good monitoring and supervision, and atthe same time providing an effective resolution mechanism, including a

deposit insurance system and financial safety nets, can help reduce thepotential risks and damaging impacts of financial instability and crisis.Yet, the bottom line should never be overlooked, that the purpose offinancial development is to support the real sector without exacerbatingalready worsening income inequality throughout Asia, as the welfare ofthe majority is the ultimate development goal. Asia still requires financialdevelopment, but development of an inclusive nature with support forSMEs, long-term financing from capital markets to promote infrastructuredevelopment (hard and soft), and more stable trade financing to promote

the regions exports and imports. Any proposed framework of financialregulation should take these factors into consideration.

NOTES

1. ASEAN13 refers to the ten members of the Association of Southeast Asian Nationsplus the PRC, Japan, and the Republic of Korea.

2. In response to Asias widening trade finance gap, the Asian Development Bank (ADB)increased the amount of risk that its Trade Finance Program (TFP) could assume to

US$1 billion at any one time from the original limit of US$150 million. The TFP seeksto: (1) close private sector market gaps by providing guarantees and loans within 24 hoursat market rates through partner banks to support trade, and (2) leverage resources bybringing in co-financing partners. Between 2009 and the first half of 2013, the TFP hadattracted US$8.4 billion in co-financing to support trade in the most challenging marketswhere gaps are proportionally the largest. The co-financing also drew private sector enti-ties into challenging markets for the first time. In general, the TFPs due diligence andrigorous monitoring of bank risk provide comfort and bring the private sector into TFPtransactions in the most challenging markets. The TFP also provides technical assistanceto help Asian companies get more and better-priced access to trade finance.


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15

IntroductionHyun Song Shin

The guiding theme of the chapters in this part of the book is that theprocyclicality of the financial system provides an organizing frameworkfor selecting indicators of vulnerability to crises, especially those that are

associated with banks and financial intermediaries.In addressing the procyclicality of the financial system, it is useful to

distinguish between the core and non-core liabilities of the banking sector.Core liabilities can be defined as the funding that the bank draws on duringnormal times and that is (mainly) sourced domestically.

When banking sector assets are growing rapidly, the core funding avail-able to the banking sector is likely to be insufficient to finance the rapidgrowth in new lending. This is because retail deposits grow in line with theaggregate wealth of the household sector. In a lending boom when credit is

growing very rapidly, the pool of retail deposits is not likely to be sufficientto fund the increase in bank credit, and other sources of funding must thenbe tapped. The state of the financial cycle is thus reflected in the composi-tion of bank liabilities.

The exact dividing line between core and non-core liabilities will dependvery much on the financial system in question and the degree of opennessand level of development of financial markets and institutions. For a devel-oped financial system, as in the United States (US) and western Europe,the distinction between core and non-core liabilities seems reasonably well

captured by the distinction between deposit versus non-deposit funding.For emerging and developing economies, more thought is neededin finding a useful classification system between core and non-coreliabilities. In an emerging economy where the banking system is open tofunding from global banks, rapid increases in the non-core liabilities ofthe banking system would show up as capital inflows through increasedforeign exchange-denominated liabilities of the banking system. For thisreason, foreign exchange- denominated liabilities of the banking sectorcan be expected to play a key role in diagnosing the potential for financial

instability.Hahm et al. in Chapter 2, which is based on Hahm et al. (2013a), examine


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the procyclicality of the financial system in Asia by investigating the degreeof procyclicality in several Asian countries. There are two strands to theinvestigation. First, Hahm et al. investigate the (semi-) elasticity of the

liability aggregate with respect to changes in gross domestic product(GDP) as a measure of procyclicality. This is accomplished by regressingthe log of bank liabilities on the log of real GDP and short-term inter-est rates. The countries examined are the Republic of Korea, Indonesia,Malaysia, the Philippines, Singapore, and Thailand. The investigationalso examines the sensitivity of the liability aggregate to the funding costfaced in the wholesale funding market, as measured by the US federalfunds target rate. (Bruno and Shin 2012b have separately investigated therisk-taking channel of monetary policy and how such a channel impacts

capital flows.)The second strand of the empirical investigation is to examine the

responsiveness of core and non-core bank liabilities to global liquidity andmeasures of the market price of risk, such as the VIX, the index of impliedvolatility of Standard and Poors (S&P) 500 options, as well as to measuresof cross-border banking activity as measured by the interoffice assets offoreign banks in the US. Bruno and Shin (2012a) have previously shownthat the interoffice assets series provides a timely and informative pictureof the role of global banks in driving cross-border capital flows.

The main findings by Hahm et al., in Chapter 2, confirm that bankliabilities in Asian countries are highly procyclical as indicated by thesignificantly positive real GDP elasticities, although the degree of procy-clicality varies across countries. In countries with relatively high real GDPelasticities, such as the Republic of Korea and Indonesia, non-core liabili-ties are more procyclical than core liabilities. Also, non-core liabilities, suchas foreign borrowings, tend to be more procyclical in the boom period.

With respect to US monetary policy, Hahm et al. find that bank liabili-ties are responsive to both domestic and the US policy interest rates, but

there are some differences across the countries studied. In the Republicof Korea and Singapore, bank liabilities tend to increase faster when USfederal funds rates are low, which indicates that US monetary policy hasimportant spillover effects on bank leverages in emerging Asian countries.

With regard to the impact of the interoffice assets of foreign banks inthe US, Hahm et al. find that bank liabilities in many Asian countriesrespond positively to US cross-border interoffice loans and the elasticitiesare higher for non- core liabilities. The impact of global market uncer-tainty, as measured by the VIX, seems less significant in Asian countries,and in many cases, the elasticity has an opposite sign.

In Chapter 3 (originally Hahm et al. 2013b), the authors provide anempirical framework for assessing the vulnerability of an economy to a


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Introduction 17

financial crisis. Following the same methodology used in 2011, Hahm et al.conduct a panel probit study of the susceptibility of emerging and devel-oping economies to a financial crisis using the non-core bank liabilities

as the conditioning variable. However, this new study differs from Hahmet al. (2011) in two respects. First, it focuses on the role of capital marketopenness in driving the relationship between non-core bank liabilities andfinancial crises. As most Asian countries have not completely opened theircapital markets, examining how capital market openness affects the extentto which non-core liabilities increase the likelihood of currency and creditcrises should yield important policy implications. In this chapter Hahm etal. adopt two measures of capital markets openness: (1) a de jureChinnIto index based on International Monetary Fund (IMF) classifications,

and (2) a de factoLane and Milesi-Ferretti index based on actual financialtransactions.

The second strand of the investigation in Chapter 3 explores how globalfinancial conditions impact the level of vulnerability to currency and creditcrises. As experienced in two previous crisis episodes in 199798 and 200708, Asian countries suffer from financial crises when their economic funda-mentals deteriorate and when global financial conditions are aggravated.Hahm et al. employ two measures of global financial conditions UScross-border interoffice loans and the VIX index of implied volatility and

analyze their relationship with the likelihood of a crisis.The main findings in Chapter 3 are as follows. First, the non-core bankliability ratio has significant predictive power for both currency and creditcrises even after the degree of capital market openness is controlled.

Second, between the two openness measures, the de factoMilesi-Ferrettiindex seems to have a superior explanatory power than the de jureChinnIto index, which suggests that actual openness could differ widely fromregulatory and institutional openness.

Third, capital market openness seems to have a significant impact on the

level of vulnerability to financial crises, not only independently but also byinteracting non-linearly with non-core bank liabilities.Fourth, the interaction effect between capital market openness and the

non-core liability ratio seems to materialize heterogeneously across cur-rency and credit crises. For a currency crisis, while capital market opennessitself tends to increase vulnerability to a crisis, the interaction term withthe non-core liability ratio turns out to be negative. Hence, an increase inthe non-core liability ratio raises the likelihood of a currency crisis lessproportionately when capital markets are more open. However, for a creditcrisis, the interaction term is positive in many cases, indicating that withmore open capital markets, an increase in the non-core liability ratio raisesthe likelihood of a credit crisis even more proportionately.


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Fifth, as conjectured, global financial conditions exert a significantimpact on the crisis incidence. A higher VIX of market risk significantlyraises the crisis incidence of emerging market countries for both currency

and credit crises. However, it is worth noting that US interoffice loans haveheterogeneous impacts on currency and credit crises. An increase in cross-border bank capital flows from the US raises the likelihood of a currencycrisis, while it reduces the likelihood of a credit crisis.

Overall results are consistent with the hypothesis that non-core bankliabilities matter more in open emerging market countries than in relativelyclosed economies. However, the impacts of non-core liabilities material-izes in highly non- linear and heterogeneous ways across different crisesepisodes. Policymakers in emerging Asian economies must therefore take

these complex interaction effects into consideration when they pursuecapital market opening by designing a careful macro-prudential policyframework as a guard against potential risks.

The discussion so far is appropriate for an economy such as the Republicof Koreas where the domestic banking sector has access to funding fromthe global banking system. However, in some financial systems that are atan earlier stage of development, or where the banking sector is restrictedby regulation from having access to the global banking system, the dis-tinction between the core and non-core liabilities of the banking system

will look different, although the same principles from the system-wideaccounting framework will continue to apply.When the domestic banking sector is mostly closed from the global

banking sector, deposits will constitute the lions share of banking sectorliabilities. At the same time, traditional monetary aggregates such as M2become highly variable and procyclical, encompassing volatile banking lia-bilities. In such instances it may be more meaningful to decompose M2 intoits core and non-core components. The non-core component may includethe deposits of non-financial companies that end up recycling funding

within the economy and hence become integrated into the intermediarysector itself. The Peoples Republic of China (PRC) and India are twoexamples of where this distinction between core and non-core liabilitiesmay be usefully employed. In both cases, foreign exchange-denominatedbank liabilities or market-based funding instruments play a much smallerrole than in a more open economy such as the Republic of Korea.

In Chapter 4, Shin and Zhao provide a firm-level analysis of the role ofnon-financial corporates acting as surrogate financial intermediaries. Thefocus of analysis is mainly on non-financial corporates in the PRC, butcomparisons are also made with non-financial corporates in other Asianeconomies.

The investigation centers on the key prediction that non-financial firms


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Introduction 19

borrow from financial markets in order to hold financial assets, in particu-lar deposits in the banking system. Shin and Zhao explore this hypothesisby examining the correlation between the financial liabilities and cash

holdings of non-financial firms. They examine the variation of the cor-relation between financial liabilities and cash holdings across countries,industries, and periods using firm-level data in the Compustat Globaldatasets for seven economies: the PRC; Japan; the Republic of Korea; andthe four largest economies in the Association of Southeast Asian Nations(ASEAN), which are Indonesia, Malaysia, the Philippines, and Thailand.

The main findings are as follows. First, among Chinese firms, finan-cial liabilities and cash holdings are positively correlated when both aredivided by sales, which is different from Oplers (1999) findings for US

firms. Second, firms in the manufacturing sector display a notably largerintermediary activity. This finding is strongest for the PRC, Japan, andIndonesia. Third, when the sample period for the PRC is divided into threesub-periods (19912001, 200207, and 200811) and the sample periodfor Japan is divided into two sub-periods (198790 and 19912011), theinteraction between the manufacturing dummy and financial liabilities ispositive and significant only in 200207 and 200811 for the PRC and in198790 for Japan, while being insignificant in all other sub-periods. Thesefindings are hard to reconcile with the financing hierarchy theory, but are

consistent with the theory of Hattori et al. (2009).The results in Shin and Zhaos chapter point to a broader theme of thefinancialization of non-financial companies. Non-financial firms havetaken on attributes of financial firms as they increase the size of theirbalance sheets relative to their activities in generating sales. As a conse-quence, they contribute to the amplification of financial cycles.

As monetary policy moves from the role of banks to the functioning ofbond markets and the availability of credit to borrowers from long- terminvestors, such as asset managers that act on behalf of pension funds and

insurance companies, the role of non-financial firms will take on increasedsignificance. The findings by Shin and Zhao in Chapter 4 should contrib-ute to a better understanding of the channels through which global liquid-ity conditions are transmitted to the domestic financial system.

Azis and Yarcia (in Chapter 5) focus on the nature and implicationsof the dramatic shift in the Asian economy since the 199798 financialcrisis, which has seen excess investments turn into excess savings. Thechapter begins with a discussion of the trend of excess savings and capitalflows in selected Asian countries by using flowof-funds (FOF) data,with a particular focus on the 199798 Asian financial crisis as a crucialturning point. The chapter then analyzes the implications of the trend onagents preferences, determines the key contributing factors to changing


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preferences among agents, and considers other economy-wide impacts ofthe trend. In particular, it highlights the potential vulnerabilities associatedwith macro-financial and socioeconomic risks. The chapter also consid-

ers the rapid surge in corporate savings after the 199798 crisis and seeksto identify the most important determinants of corporate savings. Thechapter extensively analyzes the trend and the characteristics of excesssavings with respect to five Asian economies: Indonesia; the Republic ofKorea; the Philippines; Taipei,China; and Thailand. The analysis looks attwo key time periods: pre-global financial crisis (200007) and post-globalfinancial crisis (200811). The authors conclude that surpluses usuallycome from households and deficits from corporations, except in the caseof the Philippines where corporations are net savers and the government

is a net borrower.Chapter 5 also examines the extent to which the behaviors of house-

holds, firms, and the financial sector have changed in light of the trendof excess savings, particularly since the global financial crisis. Graphicalrepresentations are utilized to analyze agents behavioral patterns, matchthe flow of the different components of liabilities and assets of each agentbased on FOF data, and estimate the trend- line for each period. The analy-sis carried out led to inferences about the impacts of the abundant liquidityassociated with excess savings and capital inflows on agents behavior, and

to the general conclusion that, as expected, agents in each country exhibitdifferent behavior as to what sources of funds they prefer and where theychoose to invest excess savings. The authors also look at the shifting trendsover time in terms of capital inflows and outflows in Asia and their impli-cations. The focus is on rising levels of capital outflows, outward foreigndirect investment (FDI) and equity investment, and capital inflows, whichin the midst of excess savings have further enhanced emerging Asiasmacro-financial liquidity. The repercussions of foreign events and othercontributing factors including the recession in the US as well as the ultra-

easy monetary policies of and growing risks in advanced economies arealso considered. The authors flag the relationship between gross inflowsand gross outflows, particularly the almost symmetrical rise of the two in2002.

This chapter further considers the potential vulnerabilities associatedwith the macro-financial and socioeconomic risks of growing excesssavings and increased capital flows, and focuses on two types of economy-wide risks: macro-financial and socioeconomic. It considers a balancingact of the benefits of increased inflows to recipient countries against thevolatile patterns of these inflows, and how procyclicality can lead to abuild-up of financial risks and imbalances. The chapter examines boththe asset side and the liability side of bank balance sheets to demonstrate


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Introduction 21

how bank-led flows can cause the risks of a banking crisis to increase, par-ticularly in times of an external shock such as deleveraging by Eurozonebanks. The authors then discuss long-term financing accessed through

regional bond markets as another type of vulnerability. Finally, Chapter 5illustrates the socioeconomic risks associated with growing excess savingsand increased capital flows, and the implications of those risks, includingthe worsening of income inequality and the subsequent effect of loweringgrowth prospects. It shows how the shift toward a greater preference forinvesting in financial assets can cause a worsening of the already unfavo-rable conditions of income inequality in Asia as only a very small percent-age of the population in each country has access to the rapidly growingfinancial sector.

REFERENCES

Bruno, V. and H.S. Shin (2012a), Capital flows, cross- border banking and globalliquidity, working paper, Princeton University.

Bruno, V. and H.S. Shin (2012b), Capital flows and the risk-taking channel ofmonetary policy working paper, Princeton University.

Hahm, J.-H., H.S. Shin and K. Shin (2011), Non-core bank liabilities and financialvulnerability, paper presented at the Federal Reserve Board and JMCB joint

conference on the Regulation of Systemic Risk, Washington, DC, September;subsequently published in Journal of Money, Credit and Banking, 45 (S1), 336,August 2013.

Hahm, J.-H., H.S. Shin and K. Shin (2013a), Monetary aggregates and procycli-cality of the financial system: an Asian perspective, working paper for ADBinterim conference, Hong Kong, China, January.

Hahm, J.-H., H.S. Shin and K. Shin (2013b), Non-core bank liabilities and vulner-ability to crisis: evidence from Asia, working paper for ADB interim conference,Hong Kong, China, January.

Hattori, M., H.S. Shin and W. Takahashi (2009), A financial system perspec-tive on Japans experience in the late 1980s, Bank of Japan IMES Discussion

Paper 2009 E-19, available at: http://www.imes.boj.or.jp/english/publication/edps/2009/09-E-19.pdf (accessed 19 July 2014).Opler, T., L. Pinkowitz, R. Stulz and R. Williamson (1999), The determinants and

implications of corporate cash holdings, Journal of Financial Economics, 52(1),346.

Shin, H.S. and Y. Zhao (2013), Monetary aggregates and global liquidity: evidencefrom individual firm data from Asia, working paper for ADB interim confer-ence, Hong Kong, China, January.


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22

2. Monetary aggregates andprocyclicality of the financialsystem: an Asian perspectiveJoon-Ho Hahm, Hyun Song Shin andKwanho Shin

1 INTRODUCTION

Financial procyclicality is a feature commonly observed in most econo-mies. However, driving factors could vary across advanced and emerg-ing market countries, and closed versus open economies. A crucial taskin mitigating procyclicality of credit growth, which is a key challenge inmacro-prudential policy, is to monitor and identify the relevant stage of

financial cycles.As we have seen from the recent credit booms in the period leading tothe global financial crisis in 200708, excessive credit growth is mirrored onthe liabilities side of a bank balance sheet by shifts in the composition offunding. Stable sources of funding available to the banking sector are, forinstance, retail deposits of household savers. However, retail deposits growslowly in line with the aggregate wealth of the household sector. In a creditboom when bank lending is growing very rapidly, the pool of retail depos-its is not sufficient to fund the increase in bank credit, and other sourcesof funding must be tapped. Consequently, the state of the financial cycle isreflected in the composition of bank liabilities.

In open emerging economies, rapid increases in the liabilities of thebanking system often show up as capital inflows through increased foreigncurrency liabilities of the banking system. Fluctuations in the cross- borderbank capital flows from the advanced economies thus lead to credit boombust cycles in emerging market countries. By engaging in foreign currencyfinancial intermediation, banks in open emerging economies are exposedto significant liquidity risk and bank- run problems. Increasing dependenceon wholesale and off-balance sheet sources in foreign currency funding

substantially raises the liquidity risk profile of banks in emerging marketcountries. Funding liquidity risk and market liquidity risk may interact


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Monetary aggregates and procyclicality of the financial system 23

in a compound way to propagate foreign currency liquidity crisis into asystem-wide banking crisis. Hence, policymakers in open emerging marketeconomies need effective measures to monitor and control procyclicality

and build-up of systemic risk that can be caused by capital flows.Recent research indicates that bank liability aggregates based on core

and non-core properties prove to be useful in monitoring the stages offinancial cycles in open emerging market countries. The proposition thatthe proportion of non-core bank liabilities can serve as a useful indica-tor of the stage of the financial cycle and the degree of vulnerability ofthe banking system to a downturn of the financial cycle has been firstpresented by Shin and Shin (2011), and further developed by Hahm et al.(2012) and Hahm et al. (2013). They propose an approach to gauging the

stage of the financial cycle by utilizing the information on the liabilitiesside of the banking-sector balance sheet. Although traditional monetaryaggregates are also liabilities-side aggregates of the banking sector, theyargue that traditional monetary aggregates can be refined and improvedupon so as to serve as a powerful set of indicators that underpin effectivemacro-prudential policies.

The objective of the present paper is threefold: First, by followingthe methodology developed in Hahm et al. (2012), we construct bankliability aggregates based on core versus non- core properties for six Asian

countries Indonesia, the Republic of Korea, Malaysia, the Philippines,Singapore, and Thailand. Second, using the liability aggregates thus con-structed, we evaluate empirical relevance of the bank liability aggregates asa measure of financial procyclicality and systemic vulnerability in Asiancountries. Third, we also empirically investigate the relationship betweenbank liability aggregates in Asian countries and global financial cycles.The chapter is organized as follows. In section 2, we provide a conceptualframework for new bank liability aggregates based on the core and non-core properties. In section 3 we construct core and non- core bank liability

aggregates for six Asian economies. Section 4 examines empirical proper-ties and procyclicality of bank liability aggregates in Asia. Finally, section5 provides a summary and concluding remarks.

2 CONCEPTUAL FRAMEWORK OF NEW BANKLIABILITY AGGREGATES1

2.1 Traditional Monetary Aggregates and the Financial Cycle

Monetary aggregates can be used as a window on the size and composi-tion of bank liabilities providing an insight into the stage of the financial


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cycle. For this reason, central banks have recently emphasized the financialstability properties of monetary aggregates. For instance, the EuropeanCentral Bank has recently shifted to interpreting their monetary pillar

increasingly as a financial stability pillar (Papademos and Stark 2010).However, the financial stability properties of traditional monetary aggre-gates are limited in nature as they are based upon the classification of bankliabilities emphasizing the transactions role of money.

As traditional classifications of monetary aggregates focus on the trans-actions role of money as a medium of exchange, the criterion is based onhow close to cash a particular financial claim is. Namely, the traditionalhierarchy of monetary aggregates goes from cash to the very liquid claims,such as demand deposits, going out to more illiquid claims on the banking

sector, such as term savings deposits. As the criterion is how easily suchclaims can be used to settle transactions, in the context of quantity equa-tion of money, this traditional monetary aggregate is more appropriate inidentifying the extent to which inflation is likely.

For financial stability purposes however, we may conceive an alternativeclassification scheme which is more directly related to the propagation offinancial risks. Rather than the money demand decisions by savers, we canlook at the money supply and funding decisions of banks. The movementof this alternative aggregate must have implications on the stage of financial

cycle and the systemic risk, which cannot be captured by ease of settlementof transactions. For instance, overnight repurchase agreements (repos)between financial institutions are claims that are short term and highlyliquid. However, the recent global financial crisis demonstrated that reposcould be highly destabilizing when higher margins are charged by creditorsin crisis episodes, setting off a spiral of distress in the financial system as awhole (Gorton 2008; Morris and Shin 2009; Adrian and Shin 2010).

Shin and Shin (2011) emphasized that an important dimension thatis not addressed in the traditional hierarchy of monetary aggregates is

who holds the claims. This dimension is important for financial stabilitypurposes as the same claim can have very different stability implicationsif they are held by heterogeneous entities. The cash deposits of a lever-aged hedge fund at its prime broker are similar to demand deposits ofhousehold savers in the banking system in terms of how liquid the claim is.However, they have very different systemic risk implications. At the otherend of the spectrum, a covered bond issued by a bank is an extremelyilliquid long-term claim that is not money-like at all. However, a coveredbond held by long-term investors such as a pension fund is similar to retaildeposits in that the funding provided to the banking sector is more stablethan a mortgage-backed security or a collateralized debt obligation (CDO)held by a securities firm.


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Hence, from the perspective of financial stability, traditional monetaryaggregates such as M1 and M2 are less useful in identifying the stage offinancial cycles. The relevant distinction is not how cash-like a claim is as

embedded in traditional monetary aggregates, but the core versus non-coreproperties that have to do with whether the claim is held by the ultimatedomestic creditors, such as households, as it is more stable. Overnightrepurchase agreements and other claims held by financial corporations onother financial corporations can be regarded as non-core liabilities whichare less sticky and more volatile.

Furthermore, we cannot readily identify traditional monetary aggre-gates with the size of the liabilities of leveraged institutions which play acrucial role in the fluctuation of financial cycles. Many of the leveraged

institutions, such as investment banks, hedge funds, and off-balance sheetvehicles, do not belong to deposit-funded banks. Hence, their liabilities arenot counted as money. In countries with a more capital-market orientedfinancial system, traditional monetary aggregates may represent only asmall proportion of aggregate size of the leveraged financial institutions.The increasing trend toward greater reliance on non-traditional, non-deposit based funding, such as interbank loans, commercial papers, andasset-backed securities, has also made traditional monetary aggregates lessappropriate for macro-prudential policy.

For countries with considerably open capital markets, foreign capitalflows play a particularly important role in financial cycles. During a creditboom when bank credits are growing rapidly, the funding required out-strips the growth of domestic deposits, and is often met by foreign capitalflows, which is reflected in the growth of short- term foreign currency bankliabilities. As such, short-term foreign currency bank liabilities can also beseen as the volatile non-core liabilities in open emerging market economies.

Overall, the classification of bank liabilities based upon the core versusnon-core properties would provide a better window on the actual exposure

of the banking sector to financial vulnerability and their willingness totake risks. As such, the relative size of non-core versus core liabilities canbe used as a useful monitoring tool to reflect the stage of the financial cycleand the degree of vulnerability to potential setbacks.

2.2 An Accounting Framework for Core and Non-core Bank Liability

Aggregates

Shin and Shin (2011) considered a basic accounting framework to clarifythe notion of core and non-core liabilities. This section follows Shin andShin (2011). Suppose that the domestic financial system consists of ulti-mate borrowers (domestic firms and households) and ultimate creditors


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(domestic households). The domestic banking sector channels funds fromultimate creditors to ultimate borrowers. There exists also a foreign sectorthat stands ready to supply funds to the domestic banking sector. Shin and

Shin (2011) show that the aggregate balance sheet identity can be repre-sented as follows:

Total core liabilities 5an

i51

eizi(li2 1) (2.1)

where eiis the equity of bank i,liis the leverage of bank i,ziis the ratioof bank is core liabilities to its total liabilities, and n is the number of

banks in the banking system. The core liabilities of a bank are its liabili-

ties to the non-bank domestic creditors (such as through retail deposits).

The non-core liabilities of a bank are either a liability to another bank,or a liability to a foreign creditor usually a global bank. Since total core

liabilities (retail deposits) are sticky and slow-moving, in equation (2.1),

a rapid increase in total bank assets (equity multiplied by leverage)

must result in lower zi values, implying a greater reliance on non-core

liabilities.

In this way, there are close conceptual links between procyclicality, inter-connectedness and the stock of non-core liabilities of the banking system.In a boom, we have the conjunction of three features:

total lending increases rapidly in a credit boom; non-core (including foreign currency) liabilities increase as a propor-

tion of total liabilities; and systemic risk increases through greater cross-holdings among finan-

cial intermediaries.

As such, systemic risk is procyclical and non-core liabilities lie at the heartof the increase in bank interconnectedness. Addressing excessive asset

growth in booms will go a long way toward mitigating systemic risks andthe cross-exposure among banks. Note also that the growth in non-coreliabilities is typically accompanied by the shortening of maturity of theliabilities. The prevalence of short-maturity liabilities is a consequence oflonger intermediation chains and the need to maintain a lending spreadfor each link in the chain given a normally upward sloping term structure.Hence, lengthening of the intermediation chains increases cross exposuresacross intermediaries.

The discussion so far suggests that the definition of core and non-coreliabilities should focus on whether the liability is to ultimate domesticcreditors or not. In practice however, the classification is not so clear-cut.For instance, the claims held by domestic non-financial corporate firms


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share features of both core and non-core liabilities, and thus are not easy

to classify. For small and medium-sized firms with an owner-manager, thebank deposits held by those firms are similar in nature with householddeposits. However, deposits can be held by large enterprises with access tomarket financing, who can issue bonds and then deposit the proceeds inthe banking system. In this case, those deposits should not be counted as acore liability, since the creditor firm is acting like a financial intermediarywho borrows in the financial markets to lend to the banks.

Therefore, to take account of such ambiguities, it would be more prac-tical to rely on a more graduated distinction between core and non- core

bank liabilities allowing intermediate categories. As shown in Table 2.1,Shin and Shin (2011) suggested a two-way classification taking account ofthe traditional concern with the liquidity of monetary aggregates on onefront, and the dimension of whether the liabilities are core or non-coreon the other front. They used the distinction to examine the case of theRepublic of Korea.

More specifically, Shin and Shin (2011) defined non-core liabilitiesbased upon instruments as the sum of: (1) bank liabilities to foreigncreditors, (2) bank debt securities, (3) promissory notes, (4) repos, and(5) certificates of deposit.2They examined the empirical properties of thenon-core liabilities of the Korean banking sector and found that the non-core liabilities have undergone substantial changes over the financial cycle

Table 2.1 Classification of core versus non-core liabilities

Core liability Intermediate Non-core liability

Highlyliquid Cash & Demand

deposits(households)

Demand deposits(non-financial corporate)

ReposCall loansShort-termFX bank debt

Intermediate Time deposit & CDs

(households)Time deposit & CDs(non-financial corporate)

Time deposit & CDs(banks & securities

firms)

Illiquid Trust accounts

(households)Covered bonds(households)

Trust accounts(non-financial corporate)

Long-term bank debtsecurities (banks &securities firms)

ABS & MBS

Source: Shin and Shin (2011).


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and traced out dramatic patterns over the two financial crises the 1997Asian financial crisis and the 2008 global crisis following the bankruptcyof Lehman Brothers.

Note that this measure of non-core liabilities is an approximation oftrue non-core liabilities as the classification is still based upon financialinstruments rather than actual claim holders. For instance, bank debt secu-rities such as debentures and CDs can be held by households, and thosemust be excluded from the non-core liabilities.

Utilizing the flow of funds data in the Republic of Korea, Hahm et al.(2012) further extended the framework to construct bank liability aggre-gates based upon who holds the claim. There are two key advantages ofusing the flow of funds data. First, bank liability aggregates classified by

claim holders can be constructed as we can utilize detailed informationon asset items of households and nonfinancial corporations in the flowof funds table. Second, unlike traditional monetary aggregates such asM1 and M2 in which interbank assets and liabilities are being netted outwithin a sector, the flow of funds data from the 1993 System of NationalAccounts (93 SNA) do not net out interbank liabilities within the bankingsector and report assets and liabilities of banks in gross terms. Therefore,we can actually figure out a much more exact profile of bank liabilitiesto financial intermediaries, which is a key component of our non-core

liabilities.Using the bank liability aggregates based upon claim holders in theRepublic of Korea, Hahm et al. (2012) examined the procyclicality of coreand non-core liabilities over the business cycle. They found that non-corebank liabilities are much more procyclical than core liabilities, as hypoth-esized in the framework above. They also found that the accumulation ofnon-core bank liabilities in the Republic of Korea is more affected by theUS monetary policy rate than the domestic policy rate. Based upon thefindings, they argued that the new framework of bank liability aggregates

based upon core versus non-core properties is a particularly useful tool tomonitor the stages of the financial cycle in open emerging market coun-tries. In the next section, we present the detailed methodologies of Hahmet al. (2012) and apply them to Asian countries.

3 CONSTRUCTION OF CORE AND NON-COREBANK LIABILITIES IN ASIAN COUNTRIES

In this section, based upon the framework above, we construct core andnon-core bank liability aggregates for the Republic of Korea and fiveother Asian countries Indonesia, Malaysia, Singapore, Thailand, and the


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Philippines. As the detailed flow of funds data required in constructing thecore and non-core bank liabilities are relatively more readily available inthe Republic of Korea, we first present the case of the Republic of Korea

to illustrate detailed methodologies and then apply them to other Asiancountries to the extent possible.

3.1 The Case of the Republic of Korea

Following the methodology of Hahm et al. (2012), we update and extendtheir dataset to include the period after the recent global financial crisisand construct detailed measures of core and non-core bank liabilitiesfor the Republic of Korea. As mentioned above, by utilizing information

in the flow of funds data, we can construct bank liabilities classified byclaim holders. In the Republic of Korea, the flow of funds data reportsthe financial flows across various sectors of the economy. Since it con-tains information on both assets and liabilities of each sector classifiedby detailed instruments, we can infer the information about who holdsthe claim. We obtained the Republic of Koreas flow of funds data fromthe Bank of Korea (BOK; http://ecos.bok.or.kr/, accessed 30 November2012).

To construct bank liability aggregates, we focus on the liabilities out-

standing (that is, stock measures) of depository financial corporations,which include domestically licensed banks, specialized banks, foreign bankbranches, bank holding companies, and non-bank depository institutionssuch as bank trust accounts and credit unions. Hereinafter, we simply referto the depository financial corporations as banks. Th

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