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For maintaining financial stability -- Healthy financial institutions a prerequisite: BIS

Our Bureau

NEW DELHI, June 5

THE Bank for International Settlements (BIS) has warned against ``a sharp and unwelcome turn away from a market-based approach to less desirable solutions'' unless policy measures could adequately trade off competing objectives with policy-makers ensurin g that the global economy reaps the benefits of ``a more efficient production and financial structure''.

In the 70th annual report released in Basle at its annual general meeting today, the world's central bankers' central bank bluntly stated that ``efficiency is not everything''. Pointing out that fairness and perceptions of fairness must also be taken int o consideration, it said ``issues of income distribution, debt relief and the protectionist policies of industrial countries, particularly towards imports of agricultural products and textiles from emerging markets, need more effective attention than the y have received thus far''.

It said that a further constraint on the pursuit of efficiency, particularly in the development of financial systems, must be considerations of safety and stability. The potential economic costs of sporadic financial crises must always be weighed against the on-going benefits of freer capital markets, it cautioned. The biggest policy challenge could be coping with a sudden reversal in the fortunes of the dollar, it said.

Exchange rate issues loom even larger from the angle of emerging market economies as they are relatively more open and even more prone to sentiment-driven swings in capital flows.

While for the moment, prospects for improved economic performance in Asia, Latin America and eastern Europe have encouraged inflows of foreign direct investment, concerns remain that external shocks or internal policy failures could abruptly put these fl ows into reverse. A heavy dependence on the technology sector and slow progress in corporate and bank restructuring might pose risks in Asia.

Though most emerging economies, including India, nominally have floating exchange rates, it is also true that many in Asia have been intervening heavily to stop a loss of competitiveness through currency appreciation. While touted as being consistent wit h the need to build reserves and better than capital controls, such policies could ultimately lead to excessive credit creation, it said, warning that this is another way to lose competitiveness.

Perhaps more pernicious is the danger that borrowers would revert to a fixed rate mentality and be encouraged to borrow once again in foreign currency at lower cost. While this might appear unlikely in the light of recent crises, the BIS said it is still ``astonishing how quickly people forget even hard-learned lessons''.

Referring to structural change and the prevention of global financial instability, it said measures directed at preventing financial crises increasingly recognise how micro-economic deficiencies could interact with macro-economic phenomena with ``insidio us effect''. As such, it said, promoting healthy financial institutions, especially banks, is a crucial prerequisite for financial stability. It noted that the largest number of crises still arise from financial institutions over-extending themselves whe n times seem to be good and then retrenching violently at a late stage.

As such the starting point must be internal governance and this would first benefit from a greater internal focus on risk-adjusted rates of return.

The proposals put forward by the Basle Committee on Banking Supervision for improving the 1998 Capital Accord, to be modified in the light of the recently-concluded consultation process, would link the minimum capital requirements for banks with well-dev eloped rating systems more closely to the banks' own internal assessments of credit. Such a linkage is clearly desirable, provided that these assessments are not biased in any way.

It said the Basle Committee has stated that market discipline could also contribute to prudent behaviour on the part of financial institutions. Credit spreads and share prices are traditional mechanisms in this regard, but subordinated debt might also be considered, it said.

Yet another important pillar of a properly functioning financial system is the underlying infrastructure; payment and settlement systems, legal and judicial frameworks and proper accounting. Given that payment systems in the industrial world alone are no w processing around $6 trillions of transactions a day, it is clearly imperative that they function flawlessly. As for the legal infrastructure, its crucial need was brought home by the practical implications of inadequate property laws in Russia and oth er transition economies. In many countries, the application of existing laws needs to be speedier and much less arbitrary than is currently the case.

Significant progress has been made towards agreement on a common set of global accounting standards and this vital work needs to be carried forward, completed and implemented, it said.

On the resolution of financial crises, the BIS called for a balance to be found between the provision of liquidity by the IMF as the world's lender of last resort and the moral hazard that such assistance engenders. There seems to be a growing consensus that official financing should be linked more closely to crisis-prevention efforts and that longer-term and repeated borrowing from the IMF should somehow be discouraged.

Ways to resolve crises through explicit debt reduction are no less `controversial', it said, adding that two sets of problems currently occupy centre-stage; bank restructuring in a large number of emerging market countries and debt reduction for an even larger number of very poor and highly-indebted sovereigns. In both cases, if the fundamental issue is who is to pay for losses already incurred, it should be those who contributed to such losses. Crises-resolution measures must be accompanied by efforts to avoid future crises.

Thus banks must not only be restructured but made efficient and profitable. In the case of debt reduction for sovereigns, steps to ensure good governance and investment in the health and education of ordinary people are crucial, it noted.