Thursday, September 11, 2008

Another Index- Financial development index

America and Britain have the most developed financial systems in the world, according to the World Economic Forum, a think-tank. Its inaugural Financial Development Report ranks 52 countries according to the strength of their financial markets, and the depth and breadth of access to capital and financial services. This wide-ranging index takes into account the quality of each country’s financial laws and regulations, its business environment, and the likelihood of a financial crisis, among other things. Rich countries scored well, whereas Latin America and Eastern Europe did poorly. Most countries had uneven performance: only Germany, America and Britain scored well across all categories.

Why is the US ranked #1 in spite of its serious financial instability and crisis?-Roubini;

The issue of financial stability is an important one that I flesh out in more detail in a chapter of the report titled “Financial Crises, Financial Stability, and Reform: Supervision and Regulation of the Financial System in a World of Financial Globalization”. This chapter analyzes in detail the episodes of financial crisis in emerging market economies and advanced economy; discusses the causes and consequences of such crisis; measures the economic and fiscal costs of such crises; discusses the debate on whether monetary and credit policy should target asset prices and asset bubbles; studies the weaknesses of financial regulation and supervision in advanced economies financial systems that led to the recent crises; and finally considers eleven separate key issues in the reform of the regulation and supervision of financial institutions in a world of financial globalization that are necessary to prevent future crisis and make them less virulent.

The eleven issues that are key in reforming financial regulation and supervision are: the distorted compensation system of bankers/traders and the related agency problems between financial institutions shareholders and their managers; the flaws of the originate and distribute securitization model; regulatory arbitrage and the instability of the shadow banking system given its reliance on short term liquid financing, high leverage and long term illiquid lending; the weaknesses of self-regulation and market discipline and the need of greater rules-based regulation; pro-cyclical capital requirements and other issues with the Basel II capital requirements; the distorted incentives of credit rating agencies; asset valuation and fair value accounting in a world where assets can be highly illiquid and hard to price; the lack of transparency in financial markets; the inadequate regulatory regime; the lack of international coordination of regulatory policies; and the issue of who will regulate the regulators, i.e. how to avoid the regulatory capture by the financial industry of the regulators and supervisors of financial institutions.

The paradox of the US and UK being ranked top at a time when there is significant turmoil, weakness and vulnerabilities in their financial systems can be explained as follows:

There is a tradeoff between greater financial innovation (that is beneficial to develop more sophisticated financial instruments allow better allocation of savings to investment and better risk diversification) and financial risk and instability that may increase if such innovation does not occur in the appropriate regulatory and supervisory regime. A country may be very financial stable with little risk of a financial/banking crisis but if this stability is the result of excessive regulation that foster little financial innovation, little competition and efficiency in financial markets and institution such financial stability will come at the cost of poorer financial intermediation that is not beneficial to long term economic growth and performance. So, excessively stable financial regimes are not necessarily ideal. Conversely, if financial innovation is excessive and occurs in a weak regulatory framework financial markets may be much more sophisticated but the risk of instability is also greater.

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