1. Domestic Markets and Financial Stability in Emerging Economies Mario Bergara Central Bank of Uruguay 19 th Dubrovnik Economic Conference June 13, 2013

2. Domestic Markets and Financial StabilityOutline On the Governance of Financial Stability Institutions

3. Domestic Markets and Financial StabilityOutline On the Governance of Financial Stability Institutions

4. Foreign investors used to stay out of domestic markets: Lack of information Transaction costs Operational risks Lower creditor protection Other macro issues However, this fact is rapidly reverting Lacking arbitrage, these markets were seen as stable sources of funding In small emerging economies, domestic markets are essentially local bonds markets What domestic markets are expected to do for financial stability? Local Markets and Financial Stability

5. Underdeveloped domestic financial markets Reliance on foreign funding and less capacity to issue domestic currency debt Overexposure to external shocks Frequent non-country specific crisis and sudden stops What domestic markets are expected to do for financial stability? Local Markets and Financial Stability

6. Reliance on external sources renders the country more subject to external shocks and non-country specific financial crisis Local markets development as a means to reduce financial fragility Keys to develop local markets and reduce currency mismatches: Stronger institutions Well defined creditor rights Low inflation More developed domestic financial market helps reduce the volatility of capital flows to emerging economies However, domestic market development entails new problems when considering the impact on financial stability What domestic markets are expected to do for financial stability? Local Markets and Financial Stability

7. Implications of volatile capital flows for macroeconomic and financial stability Growth differentials Appreciating and volatile exchange rates in emerging markets Uncertainty and volatility in the global environment Interest rate differentials Differential expectations on exchange rates Liquidity conditions and market sentiment Risks of asset price bubbles and bank lending boom Risks of capital flow stop or reversal Local Markets and Financial Stability

8. Inbound capital movements set the grounds for currency appreciation beyond the limits of other fundamentals Another secular trend of new markets discovery by massive investment funds adds further pressure on the exchange rate Investment funds increasingly search for new alphas, encouraged by historically low interest rates and buoyant international liquidity Not only the real sector suffers, but is also subject to foreign and domestic sources of real exchange rate shocks The domestic financial sector may be subject to solvency issues related to sharp changes in this relative price Inbound capital might generate trends of currency appreciation Local Markets and Financial Stability

9. As foreign investors find more attractive to enter domestic markets, they increase the aggregate demand for domestic assets Higher demand implies higher prices and lower yields, making harder for the monetary authority to pursue an interest rate target The Central Bank is forced to perform sterilized purchases of foreign currency, to prevent sharp short term currency appreciation and to satisfy the demand for domestic assets FX market tensions risk diverting the monetary authority from its primary target and might as well generate pressure on the financial system Prudential regulation and supervision have to pay special attention to FX risk issues Capital reallocation dampens the ability of monetary policy to cope with internal stabilization issues Local Markets and Financial Stability

10. Central Banks in emerging economies have use reserve requirements and caps on foreign exchange positions to limit potential imbalances derived by surges in short-term capital inflows Macroprudential instruments to limit the exposure of the financial system to systemic risks Exchange rate flexibility acts as an automatic buffer to cushion against external shocks and contribute to provide an adequate incentive structure in the economy Foreign exchange market intervention: reduce excessive volatility and currency appreciation in the current (circumstantial) financial environment, but not against long term fundamentals The macroprudential perspective contributes with more instruments to deal with short term capital flows, without affecting macroeconomic and financial stability Financial Stability and Policy Options Local Markets and Financial Stability

11. Globalization dampens the role of domestic markets as firewalls Local Markets and Financial Stability

12. External financial episodes directly affect domestic interest rates, weakening the control by the monetary authority. As emerging markets yields tend to correlate, non-country specific financial distress equally produces domestic turmoil Investment funds tend to follow pro cyclical herding behaviors in face of bad news As a result, while domestic financial markets tend to channel home-biased sources of funding in a stable fashion, their development and increasingly global arbitrage might generate some negative side-effects that may have consequences on financial stability if not correctly addressed. Domestic asset prices are increasingly determined by external factors Local Markets and Financial Stability

13. Domestic Markets and Financial StabilityOutline On the Governance of Financial Stability Institutions

14. Financial Stability in a context of Macroeconomic Stability Micro and Macroprudencial Regulation Monetary policyFiscal Policy Financial Stability Identifying relevant systemic risks and addressing externalities Monetary and fiscal policies can help to mitigate costs of aggregate weaknesses and individual failures “New issues” for Central Banks and Financial Regulators? On the Governance of Financial Stability Institutions

15. The lack of a macro-systemic approach was clear, but was the micro- prudential regulation working properly? Failure of the regulatory approach and of the organizational design of public intervention in financial markets The decentralized governance failed as well as the “light supervision” approach Supervision and regulation was poor and the organization of the Financial Safety Net was inaccurate in some places and chaotic in others A possible (dangerous) lesson from the crisis: “Everything was right except that the macro-prudential approach was lacking.” The discussion about the governance of macro-prudential policies might be “smuggling” a debate about the failure of the decentralized regulation and the need to move towards a more centralized fashion We need to get back to the conceptual determinants of the optimal Financial Safety/Stability Net: conflict of objectives, incentive structures, accountability, coordination and organizational design Current discussion influenced by situation in developed countries On the Governance of Financial Stability Institutions

16. Monetary Policy Lender of Last Resort Prudential Regulator and Supervisor Deposit Insurer and Resolution Agency Explicit conflict of objectives, right incentive structure, accountability and coordination Financial Safety Net: Governance On the Governance of Financial Stability Institutions

17. The decision-making of some crucial issues Liquidating financial institutions Mergers and acquisitions Short term financial assistance Intervening financial institutions Financial Safety Net: Governance and Conflict of Objectives On the Governance of Financial Stability Institutions

18. Separation/Unification of the Financial Safety Net agencies Relative institutional strenght Reputation and credibility Expertise and capacities Make explicit the conflict of objectives Institutional Determinants of the Financial Safety Net Design On the Governance of Financial Stability Institutions

19. The necessary consistency in supervision and regulation across markets and agents Capital markets Insurance markets Pension fund administrators Financial intermediaries and non-intermediaries Degree of Centralization of Financial Regulation On the Governance of Financial Stability Institutions

20. More centralized Efficiency due to specialization Lower power concentration Economies of scale and scope Lower bureaucratic costs Less centralized Conglomerates logic Degree of Centralization of Financial Regulation Lower regulatory arbitrage On the Governance of Financial Stability Institutions

21. Monetary Policy Lender of Last Resort Prudential Regulator and Supervisor Deposit Insurer and Resolution Agency Coordination and contribution for all agencies to comply with their respective mandates From Financial Safety Net to Financial Stability Net: Governance Ministry of Finance/ Treasury On the Governance of Financial Stability Institutions

22. Implications of systemic risks on rules and institutions Systemic risks Rules Institutions Risk-based regulation Broad perimeter Financial Safety Net Financial Stability Framework Centralized Regulation Ownership/stockholding of non-financial entities Corporate governance Regulatory treatment of public entities Exposure to common and correlated risks Interconnectedness (players and markets) Financial and real sector conglomerates/ cross border New kinds of risks as markets develop Regulatory arbitrage across entities with different licenses On the Governance of Financial Stability Institutions

23. Domestic Markets and Financial Stability in Emerging Economies Mario Bergara Central Bank of Uruguay 19 th Dubrovnik Economic Conference June 13, 2013