Financial Market Regulation and Reforms in Emerging Markets

12. Cross-Border Regulation after the Global Financial Crisis

321 12 Cross-Border Regulation after the Global Financial Crisis alejandro werner and guillermo zamarripa This chapter is about contagion among financial systems in a world that is global and interconnected. It argues that contagion effects from the recent financial crisis will have direct implications for reshaping the regulatory and supervisory framework. The period of financial and economic expansion prior to the subprime crisis was underpinned by low real interest rates and excess liquidity, which facilitated robust global economic growth. Such expansion was accompanied by high leverage , excessive risk taking, and a greater openness of financial sectors to foreign investment. This contributed significantly to a more interconnected global system , thereby increasing the likelihood of contagion among financial systems. The crisis revealed four sources of contagion: losses from toxic assets, asset and liability mismatches, decoupling and recoupling effects on financial markets, and risk aversion from market participants. The multiple sources of contagion played different roles in emerging market economies (EMEs). Toxic assets holdings did not represent a significant source of vulnerability since market participants were more risk averse and their investors less sophisticated, a situation that limited the exposure to these assets. However , the asset and liability mismatch had a differentiated effect among EMEs, The views expressed herein are those of the authors and do not necessarily reflect the views of the Ministry of Finance, Mexico. 322 alejandro werner and guillermo zamarripa depending on their financial system structure and the vulnerability of the economy to capital outflows. EMEs’ financial markets were immune to the effects of the crisis in the first stage when markets decoupled, and their financial variables remained stable. However, the prevailing situation in some developed economies and the failure of Lehman Brothers resulted in a recoupling effect that generated volatility on EMEs’ interest rate, foreign exchange, and securities markets. Despite the observed volatility in their financial markets, most EMEs did not experience signi ficant outflows. Such resilience can be explained partially by the regulatory and supervisory framework that these economies developed in the years previous to the crisis. The global financial system had become increasingly interconnected, and as a result, EMEs were subject to the effects of decisions made by risk-averse headquarters of large conglomerates operating in the region. Such decisions tried to solve liquidity or solvency problems of either the parent company or the subsidiary . For example, some of these conglomerates constrained their local lending activities to reduce their overall risk exposure. The openness of the financial industry to foreign investors increased the level of interconnection among financial systems and allowed local contagions to become global in scope. Furthermore, regulatory and supervisory oversight evolved at a slower pace than the increasingly interconnected markets and thus was not designed to appropriately mitigate the rising risks. The same variables that previously signaled local contagions in a system, such as leverage, capitalization , or funding structure, became relevant, as they may explain the occurrence of global contagion. The interconnectedness and complexity of corporate structures, as in the case of Lehman Brothers, demonstrate the lack of a legal framework to resolve the failure of a cross-border institution of such complexity . Consequently, the contagion effects from the recent crisis reveal the need for national authorities to establish an efficient global regulatory and supervisory framework. The design of the new global regulatory and supervisory framework should be based on a new paradigm, one that might reduce contagion in the global financial system through enhanced cross-border financial regulation and efficient coordination among national supervisors. This framework should: —develop a supervisory structure for coordinated assessment of global risks that will enable full supervisory oversight of financial conglomerates and their subsidiaries; —establish information exchange mechanisms for effective consolidated supervision based on mutual cooperation, consultation, and timely communication among supervisors; cross-border regulation 323 —create a resolution mechanism to coordinate cross-border failures of global financial conglomerates (including ring-fencing practices); —support effective assessment of major sources of vulnerability within the global financial system; and —identify relevant, systemically non-cooperative jurisdictions and develop measures to limit them in order to reduce the risks they pose to the stability of the financial system. This chapter begins with a description of the origins of the crisis and the market incentives that contributed to it, and then elaborates on the four sources of contagion. This is followed by an explanation of how these sources of contagion propagated the effects...