Business


16th November 1997

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Growth not by Budget alone

The business community has generallyapplauded the budget. Whether this is a public relations exercise to appear being on the side of the Government or a genuine view may not be clear. This is so as members of the business community think that their business interests are best served by appearing to be on the side of the Government. Nevertheless, some of the specific comments indicate that businessmen have been well disposed towards it and have considered the budget conducive to business expansion.

Perhaps the most significant thrust of the budget is that there is further confirmation of the Government's intent to pursue an economic strategy based on the leadership of private enterprise. Although fiscal constraints did not permit the Government to implement its promise of a further reduction in corporate taxes and reduce corporate taxation further, there were other measures which liberalised imports and reduced taxation in selected sectors to benefit private enterprise.

The great expectation after the previous budget was that private enterprise would get on with the job. The results were not as good as the expectations. The reasons for this are many. As some businessmen indicated, tax concessions and incentives alone are inadequate to ensure higher levels of investment. Even the Government's recent policies to reduce interest rates have not had the expected results. The reasons for this are that there are severe constraints which bind the economy. Foremost amongst these, is the security concern. Despite optimistic statements that the recent policies would not affect the economy adversely, there is little doubt that the desired level and types of foreign investment have not reached our shores owing to security concerns. This is specially so with respect to larger long term investments.

The second significant constraint is the lethargy and indecision in the bureaucracy. Time and certainty are two vital factors for investment. Delays in the bureaucracy are very costly to private entrepreneurs. Inability to obtain quick decisions from Government authorities still accounts for considerable hesitance to invest and private business not implementing their expansion plans.

The third constraint is our labour situation. In the Budget speech the Deputy Minister of Finance himself recognised this obstacle when he indicated that new approaches to labour issues would be a consideration of the Government. It is vital that this aspect be looked into expeditiously and some positive measures taken by the Government. In pursuing a developmental labour policy, people must be convinced that to be solely concerned with the security of the employed can hinder further employment and that countries which have developed, have had labour policies which were far more flexible and even harsh. Hire and fire appear to be two tenets of progressive labour policies. Modern enterprises require flexibility to reduce staff both owing to technological factors, as well as market changes. A firm unable to shrink its labour force in conditions of lesser demand faces unbearable labour costs, if it is unable to cut the labour force to the new conditions. This implies that many investors would rather not invest than face serious consequences after they begin production and market conditions change.

The message we like to convey is simply this. Although a budget is the cornerstone of the Government's economic policies and is fundamental to economic growth, there are other factors which are essential to get the economy moving. We have pointed out that a more effective bureaucracy, an improved labour situation and less security concerns are vital for a major thrust in economic growth. The best of budgets cannot achieve results unless these factors are also conducive to investors.


Strengthening the framework for financial stability

Weak banking systems whether in industrial, developing, or transition economies can threaten financial stability and severely disrupt macro-economic performance. As countries increasingly move toward removing remaining restrictions on their capital account transactions, and as banking assumes a more regional and international dimension, the cross border impact of banking system problems is likely to increase. These considerations have prompted calls for concerted international action to promote banking sector stability and soundness. In response, several official bodies, including the Basle Committee on Banking Supervision, the Bank for International Settlements, the World Bank, and the IMF, have intensified their examination of ways to strengthen financial stability. The Basle Committee has been at the forefront of this effort with the recent release of its Core Principles for Effective Banking Supervision. These principles constitute a blueprint for enhanced banking supervision and have become the focal point for the effort to strengthen financial sectors around the world. They also provide the foundation for a proposed framework for financial stability developed by a staff team of the IMF, which is to be published in the IMF's World Economic and Financial Surveys series early in 1998. The objective of this framework, summarized below, is to enhance IMF surveillance over banking sector issues of macro-economics significance.

While the thrust of policy efforts to strengthen financial sector performance must originate with national authorities, the IMF with its near-universal membership and responsibility to engage in surveillance of member countries' economic policies - has an important role to play in this area. The increase in IMF surveillance of financial sector issues will focus on identifying those weaknesses in financial systems - particularly in banking systems — that have major macro-economics implications. As such, a framework for financial stability centers on maintaining the soundness of relatively large and complex banking organizations — those that have the potential to create systemic problems domestically or internationally.

The IMF can make a major contribution to an effective framework for financial stability by:

Key aspects of the framework

An unstable macro-economics environment is a principal source of vulnerability in the financial system. Significant swings in the performance of the real economy and volatile interest rates,. exchange rates, asset prices, and inflation rates make it difficult for banks to assess accurately the credit and market risks they incur. Moreover, banks in many developing and transition economies are less able than those in Industrial economies to diversify these risks. Large and volatile international capital flows often add to the challenges faced by banks in these countries. While IMF surveillance will seek to improve the macro-economic framework, a structural framework for sound banking should also be supported by prudential and structural policies.

Improving management. The first line of defence against unsound banking is competent management. Most bank failures stem from inadequate management that allows the bank to acquire low quality assets and take inappropriate risk positions and fails to detect and resolve deterioration in existing assets and risk positions. Quantitative regulations, although important, cannot ensure that a bank is well run. As such, bank managers need a high degree of integrity, as well as adequate training and experience. A sound bank management appropriately delegates authority and applies prudent, well documented credit approval and risk limitation and administrative procedures.

Increasing Transparency. Most bank assets are illiquid and lack an objectively determined market value, hindering a reliable assessment of a bank's financial condition. Bank Managers are also often unable or unwilling to derive a realistic measure of a bank's impaired loan portfolio, and incentives for under-reporting or concealing data on bad loans grow as a bank's financial situation deteriorates. Opaque financial data not only inhibit effective corporate governance, market discipline, and official oversight, but distort prudential, monetary, and macro-economic analysis. Furthermore, the lack of hard data tends to encourage supervisory forbearance and makes the supervisory and judicial processes more vulnerable to political influences.

Sound banking therefore calls for timely and reliable information for use by management, supervisors, and market participants. Best practices include realistic valuation of bank assets as well as increased public disclosure and prudential reporting. To this end, the application of internationally recognized accounting standards - with particular attention to loan classification, provisioning, and income recognition rules and practices for their effective implementation - are desirable. Best practices in many countries typically go beyond disclosing traditional financial statements and provide other quantitative and qualitative information, such as the structure of the bank's ownership, risk concentration, and details of policies and practices of risk management systems. Supervisors should have the right to request such data from banks upon reasonable notice.

Limiting Public Sector Distortions. If markets are to play an important role in disciplining bank managers and owners, there must be a presumption that financial assistance will not be provided automatically to troubled banks and that owners and large creditors will not be fully protected. The broad goal for public sector policy should be to leave enough room for markets to work well enough to allow a bank's funding cost to appropriately reflect the quality of its balance sheet. The proper role of central bank lender-of-last resort facilities is to provide support promptly to illiquid but solvent institutions - typically at a penalty rate and against collateral - and to deny support to insolvent banks.

While the danger of precipitating a general loss of confidence makes it difficult to close large banks without fully compensating most depositors it is almost always possible to make the owners and large creditors bear a substantial part of the financial burden of losses. Deposit insurance arrangements are designed to compensate some classes of depositors in case of individual bank failure. They are however prone to problems of moral hazard and need to be designed to contain such problems. Effective deposit insurance and lender of last resort arrangements require a credible exit policy for problem banks. For exit to occur smoothly the financial system must be sufficiently robust to limit the spillovers from the failing institutions to the rest of the system. Problem banks should therefore be closed before they become deeply insolvent and cause major losses for their creditors.

Controlling Risk Through Oversight. Bank regulation and supervision seek to limit the adverse impact of the official safety net of risk taking and to force banks to internalize the externalities of failures. The objective of such oversight should not be to guarantee the survival of every bank but to make sure that the banking system as a whole remains sound. Banking laws and regulations seek to establish policies that allow only financially viable banks to operate; limit excessive risk taking by owners and managers of banks; establish appropriate accounting, valuation, and reporting rules; and provide for corrective measures and restrictions on activities of weak institutions. As part of their general duty to promote financial stability, banking supervisors monitor the soundness of the banking system and the adequacy of banks, as well as risk management practices and financial data and their compliance with prudential regulations. To be effective, a supervisory authority must have sufficient autonomy, authority, and capacity.

The supervision of individual banks is the responsibility of the national supervicery authority and is not an area that IMF surveillance would normally cover. Nonetheless, there are cases when inadequacy in the supervisory approach can be a cause of system weakness with macro-economic consequences, thus making it a legitimate cause of inquiry.

Strengthening the Structural Framework. The structure and concentration of bank ownership may adversely affect the performance and stability of the system. The recent trend toward larger banks and financial conglomerates, for example, increases the potential for systemic risk, which in turn increases the need for official oversight. Market perception that institutions are too big to fail also undermines market discipline and therefore, requires increased official supervision.

'' One of the issues relating to ownership concerns the desirability of state, private, or foreign ownership of banks. The track record of state-owned banks has frequently been poor. Nevertheless, these banks can operate efficiently if they conform to the same prudential rules as private banks and if they transfer their quasi-fiscal undertakings to the government budget. Since state banks in emerging markets rarely meet these conditions, privatization may be the best path to a sounder banking system — although private ownership in itself is no guarantee for good governance. Foreign-owned banks can introduce competition, professional skills, and new technology; but perhaps most important, they can reduce systemic risk because they tend not to be affected as readily by confidence problems as domestic institutions and are less likely to make claims on the official safety net.

Fostering Supervisory Coordination. The various sectors of the financial system are prone to interact with the banking system in a number of ways, and disturbances in one sector can easily spill over into the banking system. In many countries banks and other parts of the financial system are typically regulated and supervised by different national authorities. Regulatory and supervisory policies and practices must therefore be harmonized as far as possible, to reduce the scope for contagion and regulatory arbitrage. In an environment of increasing internationalization of banking that tends to undermine the effectiveness of nationally focused prudential supervision through the use of complex corporate structures and offshore derivatives, additional efforts at international harmonization of regulatory standards and supervisory practices are also essential.

Neither external market discipline nor supervisors alone can assure a safe and sound banking system. It is the appropriate combination of the two elements that encourages the competent and effective management that leads to a sounder banking system. In many countries, however, supervisors are unable to guide management, owing to political interference or insufficient resources. Moreover, embryonic markets may fail to provide the needed market disciplining forces. Thus, improvements are required in all relevant areas. - Courtesy IMF Survey


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