The Banking System in Emerging Economies: How Much Progress Has Been Made?

Banking crises in emerging markets in the 1990s were associated with major macroeconomic disruptions: sharp increases in interest rates, large currency depreciations, output collapses and lasting declines in the supply of credit. Bank credit has since recovered in a number of countries, and there have been significant changes in banking structure, performance and risk management capacity. Drawing on contributions by senior central bank officials from emerging market economies and staff of the Bank for International Settlements, the volume seeks to shed light on recent developments by addressing five broad topics. Recent trends in bank credit After peaking in the second half of the 1990s, bank credit to the private sector has recently risen in a number of emerging market economies, partly because of stronger demand for loans associated with robust growth and low interest rates, and partly because of greater supply of loans associated with improved bank balance sheets. The share of bank credit to the business sector has nonetheless declined in part because lagging investment spending has curbed corporate loan demand, and also because of the availability of financing in bond and equity markets. In some countries risk averse banks have held government securities rather than lend to the corporate private sector. Financial institutions have increased lending to households but this exposes them to new forms of risk, as illustrated by difficulties in the credit sector in Korea earlier in this decade. One concern is that banks in some countries have transferred a significant amount of interest rate or exchange rate risk to households through floating rate credit or loans denominated in foreign currency. The pace of structural change Banking systems in emerging economies have been transformed by privatisation, consolidation and foreign bank entry. Bank efficiency and performance have improved, apparently in response to a more competitive climate. More recently, reforms appear to have slowed, in part because the easy work had been done and because of alternative approaches to reform. For example, rather than engaging in full scale privatisation, countries like China and India are only gradually transferring ownership of major state-owned banks to the private sector. As for bank consolidation, it has been market-driven and foreign banks have played an important role in central and eastern Europe and Mexico, while the state has played a larger role in Asia. Increased concentration was not seen as a threat to competition and access to bank financing had improved with the growing presence of foreign banks. However foreign banks raised political concerns because of perceived high profits and were also difficult to supervise because parent banks' global goals and information flows did not always coincide with the needs of host country supervisors. Evolution in and management of risks facing banks Macroeconomic vulnerabilities (particularly to external shocks) appear to have declined, reflecting a mix of favourable temporary conditions as well as improved policies (higher foreign reserves, more flexible exchange rates, domestic debt market development and improved fiscal policies). However, some central banks were still concerned about vulnerability to certain shocks (eg to domestic demand, to increases in oil prices or interest rates or declines in property prices), particularly given the exposure of banks to interest rate or exchange rate risk and the need in some countries for further fiscal consolidation. Banks increasingly relied on systematic risk assessment procedures and quantitative risk management techniques, with lending being influenced less by government direction or special bank relationships with borrowers. However, challenges still arose from lack of data on loan histories for estimating default probabilities, and risks related to liquidity and credit risk transfer. Regarding liquidity risk, there is a need to ensure that banks rely on the interbank markets, rather than the central bank for liquidity. Regarding credit risk transfer, notwithstanding significant benefits associated with the growing use of credit risk transfer instruments, their rapid spread might in some cases outpace the capacity of financial institutions to assess and price risks. Preventing systemic banking crises One indicator of stronger banking systems is that the volatility of output and inflation has fallen in emerging market economies while their capital ratios have risen significantly. This reflects (i) policies designed to improve bank governance and information disclosure that enhances market discipline, (ii) regulatory measures to dilute risk concentration, limit connected lending, establish realistic provisioning rules and to improve inspection process; (iii) the evolution in supervisory strategy from "ratio watching" (checking bank positions against predetermined prudential ratios) to examining the bank's risk management process. The ability to take early action to deal with incipient problems before a crisis develops has also been enhanced by increased authority, independence and legal protection for supervisors. At the same time, explicit and limited deposit insurance has helped make clear that not all bank deposits are guaranteed by the government. The payment of fixed premia have encouraged banks to monitor the strictness/effectiveness of supervisory authority and ensured weak banks share the burden of any payouts. Some of these improvements have been helped by efforts to adopt international standards for best practice (Basel Core Principles for Effective Banking Supervision, Basel I and Basel II) and outside assessments of financial stability (ie Financial Sector Assessment Programs, or FSAPs). Challenges remain, including changing the culture in supervisory agencies as well as audit departments of banks towards more effective risk management, and the lack of adequately trained staff. Changing financial intermediation: implications for monetary policy Bank deregulation and global integration has on the one hand made monetary policy in emerging markets more potent by allowing a wider range of transmission channels, including asset market and exchange rate channels. Domestic bank loan rates also appear to be more responsive to changes in money market rates in countries with profit-driven banking systems, perhaps reflecting the recovery in the health in banking systems (pass through is lower in countries with weak bank systems eg post 1997-1998 crisis). On the other hand, external factors unrelated to monetary policy have also shaped bank behaviour. For example, demand for bank deposits has depended on exchange rate expectations. Global integration had also led to some convergence in long-term interest rates.