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Why Supervising the Financial Sector Really Matters
Markets and Governments: A Historical Perspective | |
By Ravi Menon | Wednesday, June 13, 2012 | |
As debates in the United States and other countries have shown, there is no clear consensus as to what role of governments should play in regulating financial markets. This tension, writes Ravi Menon of Singapore's central bank, is not new. In fact, it has been a central issue in the evolution of political economy over the last 200 years. |
 conomic policy is at an inflexion point. The financial crisis of 2008-09 has altered the way we perceive markets. The idea that competitive markets are sufficient to ensure efficient outcomes and stable economies is under heavy intellectual fire. What kind of new economic ideas will emerge from the crisis?
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| Getting the balance between markets and government right will be key to improving the people's standard of living and overall welfare. |
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This question is not just about economics. The crisis has prompted a fundamental re-think of the relationship between markets and governments. The contest is not just between economic theories, but between competing systems of political economy and models of governance.
Striking the right balance between markets and government is the central issue in policy debates over economic development — and, thus, is of vital importance to people all over the world. Accordingly, the two key questions currently being asked by policy makers around the world are:
 What is the role of governments in promoting economic growth?
What can governments do to seize the opportunities of globalization, while minimizing its downsides?
Despite the pressing nature of these questions, we have to recognize that the tension between markets and government is not new. In fact, it has been the central issue in the evolution of political economy over the last 200 years. There have been three distinct phases in this evolution.
Phase One: The rise of the market
The "rise of the market" began in the late 18th century, shaped by the writings of Adam Smith and David Ricardo. The "invisible hand" of the market guided supply and demand toward equilibrium and efficiency.
Free trade promoted specialization along the lines of comparative advantage and fostered economic growth. There was no need for central planning, beyond providing public goods like law and order. There was no macroeconomics as such — no monetary policy, no fiscal policy.
This phase came to an end in the 1930s, when the concept of self-correcting markets collapsed under the weight of the Great Depression. Falling prices, instead of bringing demand and supply into equilibrium, locked the world into a deflationary spiral. Thus began the second phase.
Phase Two: The rise of government
It was John Maynard Keynes who argued that markets were inherently unstable. Left on their own, they may not always self-correct. Government intervention was necessary to boost aggregate demand during periods of high unemployment. From these observations, modern macroeconomics was born.
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| In a more globalized and complex economy, governments have fewer levers to pull, and these levers are less potent than before. |
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The rise of government went beyond managing aggregate demand. The 1940s also saw the advent of the welfare state. Following the Beveridge Report, the United Kingdom — and soon, the rest of Europe — embarked on providing social insurance for health care, education, employment and social security.
The welfare state was enabled through redistributive taxation and government regulation. Across the Atlantic in the United States, Lyndon Johnson's "Great Society" of the 1960s expanded the role of the state in the pursuit of social justice.
Phase Three: The return of the market
This phase began with growing disenchantment with government's ability to deliver and was driven forward mainly by U.S.-based economists — although the problems they sought to address manifested themselves all over the developed world.
The stagflation of the 1970s — persistently high inflation and unemployment — called into question the ability of governments to fine-tune the economy. Meanwhile, the welfare state began to impose an unsustainable fiscal burden, not to mention a creeping entitlement mentality among the people.
Friedrich Hayek and Milton Friedman led the charge against "Big Government." They argued eloquently how an overreaching government dulled the fundamental human instincts that power the capitalist system: initiative, enterprise and the competitive spirit. The idea that markets — for all their faults — were more effective than governments in allocating resources and driving structural change, gained ascendancy.
In the 1980s, U.S. President Ronald Reagan and UK Prime Minister Margaret Thatcher reduced taxes, deregulated industries, privatized state-owned enterprises, curbed union power, and scaled back welfare programs. The global economy boomed. The collapse of the Soviet Union and the opening up of China seemed to vindicate the triumph of market capitalism. The Washington Consensus held sway from Bangkok to Budapest.
Phase Four: Balancing markets and governments
The third phase ended in 2009 with the onset of the global financial crisis and recession. We are once again at an inflexion point, but with no clarity on the paradigm going forward.
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| The choice is not between biggovernment andsmall government. What matters is what governments do, not how big they are. |
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The financial crisis has revealed significant imperfections in market mechanisms: information asymmetry, moral hazard, systemic risks and behavioral or nonrational motivators of choice. It has also revealed the inherent limitations of government: In a more globalized and complex economy, governments have fewer levers to pull, and these levers are less potent than before. Neither market fundamentalism nor central planning has worked.
Yet one thing is certain: The choice is not betweenbig government and small government. It is about creating effective government. What matters is what governments do, not how big they are.
The size of governments may well have to shrink. (The revenue base in most countries will be capped by competition and demographics.) But the responsibilities of government may well have to expand — to enable, regulate, stabilize and legitimize markets so they can work better.
Getting the balance between markets and government right, then, will be key to improving the people's standard of living and overall welfare.
| From the Washington Consensus to a Singapore Consensus? | |
By Ravi Menon | Thursday, June 14, 2012 | |
While the global financial crisis has prompted a reexamination of the roles of markets and governments, there is no clear agreement as to the proper balance between the two. Ravi Menon makes the case that yes, Europe, governments need markets — and yes, America, markets need governments. The key is that both be effective in what they do. |
 he key fallout of the global financial crisis is a battle between markets and governments. This is no idle matter. It is one of the bigger and most consequential battles of our time. Yet we may find that there is no universal balance between markets and governments that applies at all times and in all places.
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| The ideological conflict over the role of governments vis-à-vis markets is a false choice. Governments need markets and markets need government. |
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Each country may have to find its own balance. The balance between markets and government may have to calibrated and re-calibrated continually, adapting to circumstance and context. This has been the central insight of Singapore's experience. And while Singapore is a small nation compared to most others, it potentially offers insights that could be relevant elsewhere.
Singapore's approach to policymaking is not based on any of the usual "isms" so beloved of intellectuals. The two "isms" that perhaps best describe Singapore's approach are pragmatism (an emphasis on what works in practice rather than abstract theory) and eclecticism (a willingness to adapt to the local context best practices from around the world).
The ideological conflicts over the role of governments vis-à-vis markets often present a false choice. For that reason, public policy in Singapore has been guided by a deep appreciation of the critical interdependence between markets and government. Indeed, Singapore's approach can be summed up as follows: Governments need markets and markets need government.
Yes, Europe, governments need markets
That the market plays a central role in Singapore is well-known. According to the World Bank, Singapore is the easiest place in the world to do business. According to the Heritage Foundation, Singapore is the second freest economy in the world, after Hong Kong.
There are virtually no import tariffs, no export subsidies, no exchange restrictions, no price ceilings, no minimum wage, no rent control. Income tax rates are among the lowest in the world, and government expenditures as a percentage of GDP are well below most countries.
Equally — if not more importantly — government policies have been strongly guided by the application of market principles. Be it in industrial policy, medical insurance, congestion pricing, social security, regulation of utilities, or allocation of land, Singapore has assiduously applied market mechanisms and price signals.
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| A key feature of Singapore's approach has been a shift towards lighter regulation, accompanied by a more intense focus on risk-based supervision. |
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"Getting the economics right" has been a hallmark of governance in Singapore.
Yes, America, markets need governments
Economic development does not occur naturally. It needs preconditions, and if these do not exist, government needs to create them. Markets function best under some rather exacting conditions — rule of law, perfect information, absence of coordination failures, and no monopoly power. But the irony is that governments sometimes have to be in markets to enable these conditions.
This is where free marketers become disenchanted with Singapore. The government has never hesitated from guiding the development process or intervening in markets where it believes such intervention will lead to superior outcomes.
The objective of government intervention is neither to suppress nor to supplant markets, but to support and sustain them. In Singapore, government intervention has sought to harness the power of the market to manage and grow the economy.
Not all of the Singapore government's interventions have worked, but that is a reason to scale back, modify or even withdraw the intervention — not to reject the role of government altogether.
Adapting from a framework first proposed by Dani Rodrik to describe the role of institutions, we can illustrate four key aspects of how Singapore's government has intervened to try to make markets work better:
First, the government has sought to "enable" markets. This includes ensuring rule of law, property rights, and public infrastructure — functions that most governments perform. But in Singapore, enabling markets has also included industrial policy and capability development — subjects of continuing controversy in policy circles around the world.
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| Both markets and governments have been found wanting. What we need is not more of one and less of the other. We need both to be more effective. |
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Second, the government has sought to "regulate" markets. This includes supervision of the financial sector, competition regulation, and taxation of negative externalities.
A key feature of Singapore's approach has been a shift towards lighter regulation, accompanied by a more intense focus on — and practice of — risk-based supervision.
Third, the government has sought to "stabilize" markets. This is the bread-and-butter of macroeconomic management. Singapore's basic approach in monetary and fiscal policy is not far from global practices.
But its efforts to address asset price inflation and credit crises are interesting examples of targeted interventions that harness market forces.
Fourth, the government has sought to "legitimize" markets. Globalization, free trade and open markets lead to significant dislocations. Some of the sharpest debates over the role of government focus on the extent to which governments should facilitate adjustments, redistribute incomes or provide social safety nets, so as to maintain public support for market-oriented policies.
Singapore has sought to find its own middle ground on this complex challenge.
Addressing these four dimensions explicitly and using them as a guidepost to strike the right balance in the tension between markets and governments will be critical, all the more so because the global financial crisis has profoundly shaken our confidence in both markets and governments.
But mistakes and failures are bound to occur. They occur not because market participants are greedy or government officials incompetent. They occur because the world we live in is fundamentally complex and uncertain.
Both markets and governments have been found wanting. What we need is not more of one and less of the other. We need both to be more effective and to work in closer collaboration, so that public interest and private initiative are better aligned.
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| "The invisible hand of the market has often relied heavily on the visible hand of government." |
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As the Nobel prizewinning economist Amartya Sen has said: "The invisible hand of the market has often relied heavily on the visible hand of government."
Overall, Singapore's experience is that market principles are necessary to help government work better, and that good government is necessary to help markets work better.
This is not to suggest that Singapore has got the balance right. Far from it. Singapore is still an experiment, a work in progress.
If anything, the key take away from Singapore's story is to keep an open mind, measure outcomes, continually review policies and to learn from mistakes. Pragmatism and experimentation must become the watchwords in public policy.
| Why Supervising the Financial Sector Really Matters | |
By Ravi Menon | Wednesday, June 06, 2012 | |
When it comes to the role of government in regulating markets in the wake of the recent crisis, it is regulation of the financial sector that is of greatest interest. Stability is fundamental to a well-functioning financial system. But this stability does not occur naturally, argues Ravi Menon of Singapore's Monetary Authority. |
 hile financial markets are generally efficient, they are subject to market failure and occasional bouts of instability. The global financial crisis of the late 2000s is a perfect example of that.
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| As the recent financial crisis has shown, stakeholder governance and market discipline can fail quite spectacularly. |
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Moral hazard occurs when those who make loans are not the ones who bear the risk of default — or at least, theythought they did not bear the risk. Information asymmetry occurs when debt instruments are packaged into complex products whose risks investors do not understand.
When risk is neither monitored nor understood, it gets underpriced and builds up in the system. Effective regulation and supervision of the financial sector is therefore critical to promote prudent behavior and sound risk management.
The question is how to do it without stifling the market? There are no easy answers. At Singapore's central bank, the Monetary Authority of Singapore (MAS), we try to do this in three ways. First, we set healthy prudential standards. Second, we take a risk-focused approach to supervision. Third, we leverage on the market by relying on stakeholders to complement official oversight.
Healthy prudential standards. Singapore's central bank has consistently emphasized healthy prudential standards, especially in good times. Many of these are higher than international norms:
Banks keep a minimum 10% capital adequacy ratio, with at least 6% in Tier 1 capital.
Banks set aside general impairment provisions of not less than 1% of net loans and receivables, so that cushions are built up ahead of loan losses.
Housing loans are subject to an 80% loan-to-value limit. In other words, a lender has at least a 20% buffer against a reduction in collateral value.
These buffers have served Singapore well, allowing its financial institutions to ride out successive regional and global financial market stresses.
Risk-focused supervision. The crisis has highlighted the importance of getting the supervisory approach and intensity right. MAS evaluates the relative risk posed by each financial institution. It subjects the financial institution that potentially has the largest impact on the financial system to the greatest supervisory intensity.
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| In Singapore, the financial institution that potentially has the largest impact on the financial system receives the greatest supervisory intensity. |
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MAS demands substantial information and data from financial institutions in order to review their financial situations and their risk profiles. And where there are gaps, MAS makes sure the institutions provide additional, detailed answers.
Also, rather than having a fixed view of what is an acceptable level of business risk, MAS assesses this against the institution's risk management standards. Institutions engaging in complex financial businesses must be able to demonstrate that their risk-management capabilities match their risk profiles.
A risk-focused approach allows greater business latitude for well-managed institutions while retaining higher prudential requirements or tighter restrictions for weaker ones.
Relying on stakeholders. Primary responsibility for the safety and soundness of a financial institution must lie with its board of directors and senior management. It is their job to maintain adequate risk oversight of the institution's business activities. It is neither feasible nor desirable for the regulator to do this.
The government also leverages market discipline to foster prudent behavior among financial institutions. Stakeholders — such as shareholders, creditors and counterparties — have an interest in the continued financial health of the institution.
Likewise, one can assume professionals such as rating agencies and external auditors - chastened by their experiences and failings during the past crisis - will provide an independent assessment of the risks inherent in the institution and the adequacy of internal controls.
Of course, as the recent financial crisis has shown, stakeholder governance and market discipline can fail quite spectacularly. Herd behavior and irrational exuberance can lead the market to overvalue assets or underestimate risks. This is why regulation remains necessary and important.
But it would be a mistake to substitute tighter regulation for stakeholder governance and market discipline. Rather, governments should examine how to better align market forces and private incentives with regulatory objectives. A stable financial system is better assured with a combination of robust regulation, prudent corporate governance and effective market discipline.
Stabilizing markets during a credit crisis
The other key role of governments in financial markets is stabilization. While it has been convenient to blame governments for not preventing the financial crisis, let us not forget that it was action by governments around the world that prevented a complete meltdown of markets. Consider Singapore's experience in fighting the credit crisis.
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| When credit conditions had recovered sufficiently, the government pulled back. Knowing when and how to exit is an important consideration in any government intervention. |
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When the financial crisis broke out in September 2008 in the United States, the ripple effects were felt throughout the world. A systemic seizure of credit was underway and threatened to have dire spill-over effects on the real economy if the situation was not stabilized. Trade financing dried up significantly, impacting Singapore's exporters and offshore trading companies.
Singapore's Ministry of Trade and Industry (MTI) and Ministry of Finance (MOF) got together to analyze the situation. The market failure was at two levels: the supply of credit and the price of credit. For some sectors and geographies, there was an unwillingness to provide trade financing or working capital at anyinterest rate.
For other kinds of loans or borrowers, banks were willing to lend but at much higher interest rates. The way out of the logjam was for the government to underwrite a sufficiently large share of the default risk to induce banks to resume lending.
But how to do this without moral hazard? The fear was that government would end up with "lemons" — that banks would push less creditworthy loans to the government while keeping safer ones for themselves. There was real fear that the government could end up losing a lot of money without improving the access to credit for deserving firms.
In all the credit schemes drawn up by MTI and MOF, the principle that government must harness the power of the market was strictly applied. That is, the government was seeking not to replace the lending market, but to complement it.
First, the government refrained from direct lending. (Assessing credit risk is not a civil servant's area of expertise.) All government-facilitated loans were made through financial intermediaries in order to tap on their expertise in risk assessment.
Second, despite strong pressures from both banks and the industry, the government refrained from taking on 100% of the risk on any loan. For every subsidized loan, the bank assessing the loan had to have "skin in the game."
Singapore's credit enhancement schemes worked. When credit conditions had recovered sufficiently by early 2010, the government scaled back the credit enhancement schemes, reducing loan volumes and the risk-share. This let the market revert to normalcy, so that risk would not be mispriced over the longer term.
Knowing when and how to exit is an important consideration in any government intervention. |
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