1. 1 Financial Market Development: Sequencing Of Reforms To Ensure Stability Presented By V. Sundararajan Fi fth Annual Financial Markets And Development Conference On The Future Of Domestic Capital Markets In Developing Countries April 14–16, 2003, Watergate Hotel, Washington, D.C. Organized By The Brookings Institution, The International Monetary Fund, and The World Bank

2. 2 n Introduction & Central Theses n The Hierarchy of Markets n Financial Market Development n Risk Mitigation n Sequencing Outline

3. 3 Central Theses n Institutional Infrastructure n Institutional Infrastructure for Macroeconomic Control n Financial Reforms n Financial Reforms Sequenced According to the Hierarchy and Complementarity of Markets n A Strong Domestic Investor Base: n A Strong Domestic Investor Base: Foreign Capital Can Complement But Not Substitute for Domestic Investors n An Integrated Approach n An Integrated Approach to External & Domestic Financial Liberalization Market Development-Cum-Stability Requires...

4. 4 Institutional Infrastructure n Instruments & Markets n Prudential Regulation & Supervision n Market Infrastructure n Policy Transparency n Payment Settlement Arrangements n Information, Accounting & Disclosure

5. 5 Asset-Backed Securities & Derivatives Corporate Bonds & Equities Government Bond Market Treasury Bill Market & Foreign Exchange Markets Money Market The Hierarchy of Markets

6. 6 n Money Markets: n Money Markets: The Foundation of All Capital Markets & Interest Rate Setting n Government Bond Market: n Government Bond Market: Backbone of All Securities Markets & Yield Curve n Money & Government Bond Markets : n Money & Government Bond Markets : Highly Interdependent n FX Market: n FX Market: “Entry Market” for Foreign Investors Markets are Hierarchical and Interdependent

7. 7 Money Market n Central Bank Liquidity Management n Banks Liquidity Management n Interest Rate Setting & Transmission Foundation of Financial Markets

8. 8 Money Market Development n Central Bank Role n Soundness of Financial Institutions n Repurchase Agreements n Prudential Criteria for Market Participation n Payment Settlement Arrangements Critical Factors

9. 9 FX Market Development n Central Bank Role n Soundness of Market Participants n Degree of Competition n Dissemination of Information n Impediments to Price Discovery Critical Factors

10. 10 Govt Bond Market Development n Commitment to Market-Based Financing n Bond Design: Standardize, Concentrate in Benchmark Securities, Issue Regularly n Regulatory Incentives: Remove Obstacles to Competition, Tax Distortions n Timing: Short-Term First, Long Term Later n Market Intermediaries: Use Primary Dealers & Develop Institutional Investors Critical Factors

11. 11 Corporate Bond & Equity Market Development n Regulatory & Legal Framework n Corporate Governance & Disclosure n Financial Information & Prices n Design of Market Infrastructure n Clearing & Settlement Systems

12. 12 Institutional Investors n Enhance Transparency, Market Discipline, Corporate Governance & Shareholder Rights n Provide a Framework for Long-Term Capital Accumulation n Act as a Stable Source of Demand for Securities n Intensify Competition Among Intermediaries Are Critical Because They...

13. 13 Risks Grow As Markets Develop n Complexity & Dimensions of Risks Rise as New Markets & Instruments Are Added n Financial Risks n Macro Risks n Risk Mitigation Policies Should be Comprehensive

14. 14 Risk Mitigation Risks in Each Market Need to Be Effectively Managed Before More Risks Are Injected into the Financial System Key Principle

15. 15 Pillars of Risk Mitigation n Prudential Supervision & Market Conduct n Bank Restructuring & Recapitalization n Design of Market n Risk Controls in Settlement System n Choice of Market Infrastructure

16. 16 Pillars of Risk Mitigation n Design of Central Bank & Debt Management Operations n Intervention Procedures n Macroprudential Surveillance n Adjustment of Macro-Policies to Limit Risks & Volatility From Financial Reforms

17. 17 Money Market n Credit Risk: n Credit Risk: Financial Disclosure, Credit Risk Analysis & Pricing, Frameworks for Repos & Collateral n Liquidity Risk: n Liquidity Risk: Maturity Mismatch Limits, Liquid Assets, Back-Up Credit Lines, Liquidity Management n Central Bank Operating Risk: CB Operating Procedures, Risk Controls, Loss Sharing Arrangements in Payment System Risks & Risk Mitigation Measures

18. 18 Foreign Exchange Market n Exchange Rate Risk: Exposure Limits, Net Open Position Limits, Capital Requirements, Hedging Instruments n Credit Risk: n Credit Risk: Credit Risk Analysis & Pricing, Underwriting Standards n Liquidity Risk: n Liquidity Risk: Maturity Mismatch Limits, Transparent Trading & Market Conduct n Central Bank Operating Risk: Intervention Policies, Macro-Policy Consistency, Guarantees Risks & Risk Mitigation Measures

19. 19 Government Bond Market n Settlement Risk: Dematerialize Securities, Automate Settlement, Monitor Members n Liquidity Risk: n Liquidity Risk: Reduce Fragmentation, Develop Benchmark Securities, Use Primary Dealers n Interest Rate & Rollover n Interest Rate & Rollover Risks: Prudential Requirements for Risk Management n Market & Credit Risks: Standardize Contracts, Improve Credit Risk Pricing, Use Rating Agencies, Transparency on Large Positions Risks & Risk Mitigation Measures

20. 20 Equity Market n Counterparty & Settlement Risk: n Counterparty & Settlement Risk: Capital Requirements, Supervision, Membership Restrictions, Central Counterparty, Early Warning System n Market & Liquidity Risk: n Market & Liquidity Risk: Accounting & Auditing Standards, market Transparency, Valuation Requirements, Exposure & Concentration Limits Risks & Risk Mitigation Measures

21. 21 Capital Account Liberalization n Capital Account Liberalization & Domestic Financial Reforms Should be Integrated n Capital Account Opening Amplifies Existing Risks & Creates More of Them n The Hierarchy of Markets & Risks Provide Key Benchmarks & Principles Key Issues

22. 22Sequencing n First Priorities Are Monetary Policy Instruments & Money & FX Markets n Policies Must Be Comprehensive & Address Interdependencies & Linkages Among Markets n Market Development Measures Must Be Accompanied By Prudential & Supervisory Measures to Contain Risks Selected Key Principles

23. 23 Sequencing n Initial Financial Structure of Firms Affects Pace of Reforms n Reforms Requiring Long Lead Times For Capacity Building Should Start Early n Liberalization of Capital Flows Should Be Sequenced to Reinforce Domestic Financial Reforms n Transparency & Data Disclosure Practices Should Support Capital Account Opening Selected Key Principles (Continued)

24. 24 Hierarchy of Markets Type of Measures Money & Exchange Market & Related Central Bank Reforms Government Bond Market & Public Debt Management Corporate Debt & Equity Markets Derivatives & Asset- Backed Securities M arket Development  Entry  Trading & settlement  Information, governance Risk Mitigation  Prudential supervision  Risk controls  Macroprudential surveillance Stylized Sequencing I

25. 25 Hierarchy of Markets Type of Measures Money & Exchange Market & Related Central Bank Reforms Government Bond Market & Public Debt Management Corporate Debt & Equity Markets Derivatives & Asset- Backed Securities Financial System Infrastructure  Accounting & disclosure  Insolvency regime  Information, governance Capital Account Liberalization  FDI  Portfolio equity  Long term debt  Short-term debt Stylized Sequencing II

26. 26 Sequencing n Sequencing Implies a Critical Mass of Reforms at Each Stage of Market Development n No Unique Sequencing or Pace—Depends on Country Specific Institutional Circumstances & Initial Conditions n Comprehensive Approach to Identifying Risks to Monetary Control & Financial Stability n Macroprudential Surveillance is Key Complement to Prudential Surveillance