Trust is the cornerstone of the financial industry. But it should also be added that trust alone is not enough. We also need to have a good dose of healthy scepticism. The reason for this is that we must avoid, on the one hand, overly trusting market mechanisms or, on the other hand, overly trusting in regulation. This is because of the rapid changes in the financial system and how risk is transmitted.
Bank of Thailand governor Prasarn Trairatvorakul says economic and financial liberalisation is a powerful driving force that is rapidly reshaping our financial landscape.
The last crisis showed how financial innovation and the complexity of the bank business model overtook risk management and regulation in the West. In Asia, meanwhile, economic and financial liberalisation is a powerful driving force that is reshaping our financial landscape rapidly. This could potentially open up the gap between risk and our ability to manage it.
So what should be our strategy to build trust but avoid being blinded by our sense of security?
The strategy to deal with this is to have trust that is counterbalanced by well-informed debate on risk management, supervision and good governance. So we need a good dose of well-informed scepticism as well as a financially literate public.
WHERE ARE WE TODAY?
In all of these reforms _ be they the Basel Committee or the Financial Stability Board (FSB) _ the questions we ask are these. Have we done enough to rebuild trust and secure financial soundness? Is the international standard right for the local context? Are there unintended consequences such as bad side-effects?
Getting it right, with the right balance and right timing, is very difficult. This is especially so when the dust has not settled and the real economy is still vulnerable. Indeed, five years after the crisis erupted in the United States, we are still seeing the spread of impact in Europe and deleveraging of European banks.
From Thailand's own bitter experience of the 1997 crisis, the combined impact of all the economic and financial sector reforms was hard to gauge beforehand. The design of the reform package did not anticipate the effect of the contagion spreading to the rest of Asia and our trading partners. The key lesson is that, even with our best effort to get the reform right, we may still fumble.
So, how should Asia think about the impact of the global regulatory reform?
For Asia, although the banking system has been quite resilient to the crisis, these regulatory reforms carry high stakes for us, especially for our future development.
The reforms such as Basel III are, to a large extent, designed to correct major weaknesses in Basel II that allowed the crisis to emerge in Western countries. These weaknesses included undercapitalisation, overleveraging, inadequate liquidity and procyclicality of the banking system. So, in so far as Basel III would make these banks safer, it would contribute to stability of the global economy.
However, the weaknesses that were targeted by Basel III did not cause damage in Asia. This is mainly because the banking model here tends to be simpler, understandable and traceable. The Western system, on the other hand, is so complex that no one, not even the CEO, could understand the bank's structure and activities.
The value of this simpler model is that bankers know what is going on in their banks. Supervisors can keep very close eyes on their activities. As a result, banks in Asia were not as prone to the problem of massive overleveraging, undercapitalisation or underpricing of risk of complex derivatives. So from this perspective, the significant improvement of Basel III over Basel II is in addressing the problem of procyclicality and the adoption of a macroprudential approach in our policy framework. This is a major contribution of Basel III going forward.
The key emphasis of Basel III is to strengthen capital bases. While this is important, I regard this as only a second line of defence. The first line of defence is a good risk management system and strong governance. Asia's simpler banking model, and reforms to strengthen bank risk management and risk-based supervision, help to foster a strong first line of defence.
But we would risk a false sense of security if we believe we can depend just on our simpler banking model. With economic and financial liberalisation, especially propelled by regional economic integration such as the Asean Economic Community (AEC), that simpler banking model is changing.
BASEL III AND SIDE-EFFECTS FOR ASIA
There are some concerns about unintended consequences from Basel III that bankers and regulators in Asia have voiced to the standard setters.
One of the most important and immediate consequences would be the impact on trade finance, which is a critical issue for emerging economies and Asia. This is because our economies and financial structure are more dependent on it, compared with Western economies.
International trade is a major driver of GDP as our exports are part of the global and increasingly integrated regional supply chain. However, many of our exporters are SMEs, not large conglomerates. These local SMEs rely on bank financing as our financial system remains more bank-based than market-based. The suppliers of trade financing are still banks in Western countries, especially European banks. The deleveraging of European banks can reduce the supply of trade financing and impact growth and development.
To address this, it is important the Basel Committee recognises that trade financing has a relatively large impact on Asia, compared with the Western economies for which Basel III is mainly geared. Treatment of trade financing in leverage ratio framework will create an incentive for banks to shift away from trade financing towards other types of financial transactions, including derivatives that have a lower impact on leverage ratios but can earn higher returns. This is because they are assigned a lower credit conversion factor even though trade financing is less complex, more familiar, has low liquidity risk as it is self-liquidating and, most importantly, it clearly serves the real sector.
We believe these rationales argue for a more appropriate treatment of trade financing to ensure that the Basel III framework is appropriate for Asia. The current effort of the FSB to survey unintended consequences of reforms on emerging markets is welcomed.
For Thailand, we aim to adopt the Basel III framework in accordance with the Basel Committee timeline.
After industry consultation, we believe that Thai banks will be well placed to implement the Basel III framework as their capital positions are well above the minimum requirement of 8.5%. The Basel III framework will help strengthen the banks' capital and risk management.
One of the major improvements of Basel III from Basel II is consideration of cyclicality, with requirements for conservation and a counter-cyclical buffer. However, we believe that prudential measures, such as conservative provisioning designed to be counter-cyclical, should also be given due credit for achieving the same aim when implementing Basel III buffers. This would help avoid the double requirement on capital maintenance. Of course, we strongly support better treatment of trade financing to ensure that Basel III is supportive of stable economic growth.
KEY TREND IN ASIA
Asia faces a challenge of steering a balance between liberalisation and strengthening regulations.
The Asean economic integration under the AEC, which has set the landmark date of 2015, has progressed substantially on the free flow of goods and services as well as direct investment. Financial sector integration is also set to speed up. The plan is to provide an efficient and safe payments system in the region to facilitate trade and retail clients as well as support payments and settlements of securities in our capital markets.
The road for AEC goods and services to flow has been built; we are now making it better. Payments should be easier, cheaper, faster, safer and embrace e-technology. Banking sector integration will work towards allowing the entry of Asean banks into other member countries. We are discussing the prudential criteria for qualified Asean banks. We expect to reach a conclusion by the end of this year, with implementation to begin in 2014.
So, given that the road is built, the financial intermediary or the carrier is set to operate cross-border services more widely. Capital account liberalisation is also being speeded up with the removal of capital controls, equivalent to having fewer customs and immigration checkpoints at our borders. Capital market integration will act as catalyst to speed up the developments by expanding products, competition and the flow of financial assets.
The AEC will also serve to better integrate Asean into the other regional economies and supply chain _ that is, to integrate Asean plus 6.
Thailand is prepared for this, and our plans are being implemented on schedule. These are the financial sector master plan phase II for the banking sector, the capital market development plan and the payment road map. Our capital account liberalisation plan is undergoing industry hearings.
These forces will shape the demand for financial services and supporting infrastructure going forward. The key outcome will be demand for a broader set of financial products and services to serve regional cross-border trade and investment. The economic growth and growth of wealth in Asia will require better wealth management services.
We have come full circle. The simple banking model that has served Asia well so far will not be adequate to serve our growing future needs. So our banks will have more products, a more complex risk profile, more connections with the global capital market, more reliance on IT infrastructure. The regulations being discussed at Basel and the FSB will become increasingly relevant to us.
To go forward, we need to create trust in the risk management system and supervision, not just in our country but also in our neighbours in Asia. Having a global standard is a help in fostering this trust if we and our neighbours adopt the same standard. The challenge is that we also need to make the standard appropriate for us. To do this, both banks and regulators across the region need to work together.
This symbiotic relationship is how we get the trust and healthy dose of scepticism to keep our financial system safe and efficient.
Prasarn Trairatvorakul is governor of the Bank of Thailand. The above article has been excerpted from his keynote speech delivered yesterday to the Asian Banker Summit 2012 on the theme "Trust as a Pillar of the Industry".