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Procyclicality of Financial Systems in Asia
Stefan Gerlach; Paul Gruenwald
ISBN: 9781137001535
DOI: 10.1057/9781137001535preview
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Stefan Gerlach and Paul Gruenwald
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Procyclicality of Financial
Systems in Asia
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Edited by Stefan Gerlach and Paul Gruenwald
10.1057/9781137001535preview - Procyclicality of Financial Systems in Asia, Edited by Stefan Gerlach and Paul
Gruenwald
© International Monetary Fund 2006
All rights reserved. No reproduction, copy or transmission of this
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The authors have asserted their right to be identified as the authors of this
work in accordance with the Copyright, Designs and Patents Act 1988.
First published in hardcover 2005
First published in paperback 2007 by
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Library of Congress Cataloging-in-Publication Data
Procyclicality of financial systems in Asia / edited by Stefan Gerlach and
Paul Gruenwald
p. cm.
Includes bibliographical references and index.
Contents: Procyclicality and volatility in the financial system: the implementation of Basel II and IAS 39 – Sources of procyclicality in East Asian
financial systems – Procyclical financial behaviour: what can be done?
ISBN 1–1–4039–8751–3 (cloth) 0–230–54700–1 (pb.)
1. Financial institutions–Asia. 2. Business cycles–Asia. 3. International
finance. I. Gerlach, Stefan. II. Gruenwald, P. (Paul).
HG187.A2P76 2006
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List of Tables
vi
List of Figures
viii
Acknowledgments
ix
Participants and Other Attendees
x
Foreword
xiii
1
Introduction
Stefan Gerlach and Paul Gruenwald
1
2
Procyclicality and Volatility in the Financial System:
the Implementation of Basel II and IAS 39
Ashley Taylor and Charles Goodhart
9
Comments on “Procyclicality and Volatility in the
Financial System: the Implementation of Basel II and
IAS 39”
David Burton
William A. Ryback
José Viñals
3
Sources of Procyclicality in East Asian Financial Systems
R. Sean Craig, E. Philip Davis and Antonio Garcia Pascual
Comments on “Sources of Procyclicality in East Asian
Financial Systems”
Han Mingzhi
Tarisa Wantanagase
4
Procyclical Financial Behavior: What Can Be Done?
Philip Lowe and Glenn Stevens
Comments on “Procyclical Financial Behavior: What Can
Be Done?”
Már Gudmundsson
Eiji Hirano
Andrew Sheng
Index
38
44
47
55
124
130
137
161
168
173
176
v
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Contents
List of Tables
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
3.9
3.10
3.11
3.12
3.13
3.14
3.15
3.16
A1
A2
A3
A4
Selected research on capital charge cyclicality,
reproduced from Table 4 of Kashyap and Stein (2003)
Correlation coefficients with fourth difference of
log of real GDP
Correlation coefficients with fourth difference of
log of real GDP – cyclical asymmetries
Correlation coefficients with fourth difference of
log of real house prices
Correlation coefficients with fourth difference of
log of real GDP
Correlation coefficients with fourth difference of
log of real house prices – cyclical asymmetries
Correlation coefficients with fourth difference of
log of real GDP – cyclical asymmetries
Exposure of international (BIS) banks to Asian
countries
Determinants of credit growth, panel estimation
Equations for loan growth
Equations for bank lending margin over short-term
interest rate
Equations for bank provisioning rate
Equations for advanced and emerging market
economies
Equations differentiating foreign and domestic effects
Varying property price proxies
Equations differentiating foreign and domestic effects
using residential property prices
Estimates for public bank ownership dummy
Determinants of credit growth, panel estimation
Determinants of credit growth, panel estimation
Correlation coefficients with fourth difference of
log of real GDP – cyclical asymmetries since 1990
Correlation coefficients with fourth difference of
log of real GDP – cyclical asymmetries since 1990
17
59
60
61
61
62
63
75
81
84
86
88
90
92
95
96
101
106
107
111
112
vi
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2.1
List of Tables vii
A5
113
114
114
115
116
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A6
A7
A8
A9
Correlation coefficients with fourth difference of
log of real house prices – cyclical asymmetries
since 1990
Number of banks per country
Characteristics of the Bankscope sample
Equations for Hong Kong
Equations excluding Japan
10.1057/9781137001535preview - Procyclicality of Financial Systems in Asia, Edited by Stefan Gerlach and Paul
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List of Figures
2.2
2.3
3.1
3.2
3.3
Capital inflows, real GDP growth and credit rating in
Indonesia, Korea, Malaysia, the Philippines, Taiwan,
China and Thailand
Trend and cycle: Basel I and II compared
Does Basel II add to procyclicality?
Credit and asset price deviations from trend
Growth rate of banking credit and GDP 1991–2002
Banking credit/GDP 1991–2002
41
49
50
65
125
126
viii
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2.1
We are very grateful for the support and encouragement received
from Joseph Yam, Agustín Carstens and David Burton.
We would also like to thank those who contributed the excellent
logistical support that made the seminar a success. On the HKIMR
side, Matthew Yiu and Emily Cheng took care of numerous details in
making sure the arrangements were top notch. They also played a
key role in helping to coordinate the production of this volume. On
the IMF side, Ms Atta Tse and Mr Alfred Wong of the Hong Kong SAR
sub-office smoothly handled a truly impressive number of organizational details, thereby contributing to a very happy (and hence productive) group of conference participants.
Last but not least, we would like to thank Amanda Hamilton and
Katie Button of Palgrave Macmillan, without whose expertise and,
most importantly, patience, we never would have gotten this volume
off the ground.
ix
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Acknowledgments
Participants and Other Attendees
David Burton is Director, Asia and Pacific Department of the
International Monetary Fund.
Agustín Carstens is Deputy Managing Director at the International
Monetary Fund.
K. C. Chan is Dean, School of Business and Management at the Hong
Kong University of Science and Technology.
Gerard Dages is Vice President, Emerging Markets and International
Affairs at the Federal Reserve Bank of New York.
Charles Goodhart is Professor of Economics at the London School of
Economics.
Már Gudmundsson is Deputy Head, Monetary and Economic
Department at the Bank for International Settlements.
Maximilian Hall is Professor of Banking and Financial Regulation at
Loughborough University.
Mingzhi Han is Director-General, International Department at the
China Banking Regulatory Commission.
Eiji Hirano is Assistant Governor at the Bank of Japan.
Kevin Ho is Permanent Secretary, Financial Services and the Treasury
(Financial Services) in the Hong Kong SAR Government.
Stefan Ingves was Director, Monetary and Financial Systems
Department at the International Monetary Fund and is currently
Governor of the Riksbank.
Sang-Kuang Ooi is Deputy Governor of Bank Negara Malaysia.
x
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Participants
Participants and Other Attendees xi
Peter Pang is a Deputy Chief Executive of the Hong Kong Monetary
Authority.
William Ryback is a Deputy Chief Executive of the Hong Kong
Monetary Authority.
Andrew Sheng is the former Chairman of the Hong Kong Securities
and Futures Commission.
Glenn Stevens is Deputy Governor at the Reserve Bank of Australia.
Amando Tetangco was Deputy Governor for the Banking Services
Sector at the Bangko Sentral ng Pilipinas, and is currently Governor,
Bangko Sentral ng Pilipinas.
José Viñals is Director General, International Affairs at the Banco de
España.
Tarisa Watanagase is Deputy Governor, Financial Institutions
Stability at the Bank of Thailand.
Wong Fot Chyi is Executive Director, Macroeconomic Surveillance
Department at the Monetary Authority of Singapore.
Joseph Yam is Chairman of the Hong Kong Institute for Monetary
Research and Chief Executive of the Hong Kong Monetary Authority.
Also in attendance
Sean Craig is Senior Economist, Monetary and Financial Systems
Department at the International Monetary Fund.
Stefan Gerlach was Director of the Hong Kong Institute for Monetary
Research and is currently Head of Secretariat, Committee on the
Global Financial System at the Bank of International Settlements.
Paul Gruenwald is the International Monetary Fund’s Resident
Representative in Hong Kong SAR.
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Yung-Chul Park is Professor, College of Political Science and
Economics at Korea University.
xii Participants and Other Attendees
Alfred Kammer is Adviser, Office of the Deputy Managing Director
at the International Monetary Fund.
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Julia Leung is an Executive Director (External) of the Hong Kong
Monetary Authority.
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Gruenwald
In November 2004, the Hong Kong Institute for Monetary Research1
and the International Monetary Fund (IMF) co-hosted a one-day
seminar on the procyclicality of financial systems in Asia. The event
took place at the Hong Kong Monetary Authority (HKMA).
The seminar was the brainchild of Norman Chan, former Deputy
Chief Executive of the HKMA. Mr Chan argued that while policymakers across Asia continued to be concerned about the tendency for
financial sector activity to amplify real sector activity, there had been
very little regional dialogue on this issue. Indeed, he noted that the
bulk of the analytical work and all of the conferences to date had
focused almost exclusively on European and US experiences. Mr Chan
thought that an Asia-based and Asia-focused event on the topic was
both appropriate and overdue, and asked whether the IMF would lend
its support to the idea. The Fund, with strong support from its management, was happy to agree.
Thus, the objective of the seminar was to bring together for the first
time senior policy-makers from across the Asia region, academics and
staff of international organizations to share experiences in identifying, measuring and addressing financial sector procyclicality in the
Asian context. The aim of the seminar was functional – it was pitched
at practitioners rather than academics, and the work and discussions
were more in the spirit of “how to” rather than trying to arrive at crisp
theoretical results. The present volume brings together the three main
discussion papers of the seminar as well as comments on those works
by key participants.
The conference was organized by Stefan Gerlach, former Director of
the Hong Kong Institute for Monetary Research and former Executive
Director of the HKMA’s Research Department, and Paul Gruenwald,
the IMF’s Resident Representative in Hong Kong SAR. They also edited
this volume.
It is our sincere hope that this volume2 and, more generally, the
process begun by the seminar, will be the first step in a long and
fruitful regional dialogue. The ultimate aim is to work towards a better understanding of the nature and consequences of procyclicality
xiii
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Foreword
xiv Foreword
of financial sectors in Asia as well as the formation of appropriate,
welfare-enhancing policy responses.
JOSEPH YAM
AGUSTI´N CARSTENS
Deputy Managing Director
International Monetary Fund
Note
1. A research institute affiliated with the Hong Kong Monetary Authority.
2. Nothing contained in this book should be reported as representing the
views of the IMF, its Executive Board, member governments, or any other
entity mentioned herein. The views expressed in this book belong solely
to the authors.
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Chairman
Hong Kong Institute of Monetary Research
1
Introduction
The procyclicality of financial systems has received an increasing
amount of attention from policy-makers, academics and international organizations in recent years. This heightened interest
stems from a combination of the ongoing globalization of finance,
the role of the financial sector in various emerging market crises in
the late 1990s and the potential impact on financial sectors of the
upcoming implementation of the Basel II Accord.
Clearly, some degree of financial sector procyclicality is a characteristic of any normally functioning economy. In the simplest of
models, the expansionary phase of the business cycle exhibits rising
investor and consumer confidence, leading at some point to a rise in
the demand for credit that exceeds the rate of economic growth.
This demand for credit, which might take the form of a “boom,” is
further bolstered by a rise in property prices and other asset values
that can be used as collateral, further raising confidence and the
capacity to borrow, and so on. In downturns, these forces reverse,
leading to a contraction in credit and asset values that is usually
more pronounced than the slowdown – or even reduction – in the
growth of key macroeconomic aggregates.2
At issue is whether the observed procyclicality of the financial
sector is excessive. If it is indeed judged to be so under some circumstances, then policy intervention can – if used wisely – improve economic outcomes and, thus, general well-being.
The policy-makers’ tasks are therefore: (i) to assess whether financial sector procyclicality is excessive; (ii) if deemed so, to determine
what are the causes; and (iii) to decide which policy instrument(s)
1
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Stefan Gerlach and Paul Gruenwald1
to use to achieve the desired outcomes. Alas, this is easier said than
done. On the first of these, there is no hard and fast rule. Policymakers will likely need to rely on their judgement, particularly as
regards the size and nature of any imbalances or weaknesses that
may be emerging in the various sectors of the economy. The second
is the subject of considerable ongoing theoretical and empirical
investigation. Some researchers point to the pricing of risk over the
cycle, others to the incentives facing economic agents and their
impact on planning horizons, others to “institutional memory loss,”
while still others would point to regulatory structure itself as a possible culprit. Finally, once the policy-maker has made an assessment
of the cause of any excessive procyclicality of the financial system,
the choice of which policy instrument to use comes into play.
Should it be supervisory policy? Monetary policy? Others? The
choice of policy to combat excessive procyclicality has itself
spawned an entire debate, with no clear answers.
To date, most studies and conferences on the procyclicality of
financial systems have looked at the issue in a “Western” context.
It was hoped that hosting a modest-sized seminar on this issue from
an Asian perspective with experiences based on developments in
Asian financial systems would help to begin a dialogue between the
various parties that have been individually studying or grappling
with this issue, yield additional policy insights based on Asian
experiences and stimulate a research program.
With these aims in mind, on November 22, 2004, the Hong Kong
Institute for Monetary Research (HKIMR) and the International
Monetary Fund (IMF) co-hosted in Hong Kong a high-level, one-day
seminar entitled “Managing Procyclicality of the Financial System:
Experiences in Asia and Policy Options,” which sought to bring
together senior policy-makers from around the Asia region, academics and officials from international financial institutions. To our
knowledge, the conference was the first – and remains, at least at
the time of publication, the only – event on this important issue in
the Asian context.
The seminar was organized into three sessions, each comprising a
main paper for discussion and a number of prepared comments,
which were followed by an open floor discussion. The first session
was intended as a theoretical roadmap to help set the stage for the
subsequent modules. Charles Goodhart of the London School of
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2 Procyclicality of Financial Systems in Asia
Economics (LSE) presented a paper he co-authored with Ashley
Taylor, also of the LSE. The second session focused on the experiences of key Asian emerging market financial systems with procyclicality. The background paper was written by an IMF team
headed by Sean Craig of the Fund’s Monetary and Financial Systems
Department. Stefan Ingves, then Director of the Department, presented the paper. The third and final module was devoted to policy
options and the way forward, with Glenn Stevens, Deputy Governor
of the Reserve Bank of Australia, presenting a paper he co-authored
with his colleague Assistant Governor Philip Lowe.
The theoretical roadmap
In presenting the paper entitled “Procyclicality and Volatility in the
Financial System: the Implementation of Basel II and IAS 39”
(Chapter 2), Charles Goodhart focused on the effects of the revision
of the Basel Accord on Banking Supervision (Basel II) and International Accounting Standards (IAS). He noted that the impact of
Basel II on procyclicality depends on the time horizon over which
banks assess risk. Specifically, banks that use point-in-time estimates
of risk based on current default experiences are likely to be more
procyclical than banks using through-the-cycle estimates of risk
based on average default rates over the cycle. The latter will tend to
slow credit growth by building up capital and provisions in upturns,
which will be available to cushion losses and limit the contraction
of credit in downturns. Supervisors should consider how to use the
discretion provided by Pillar II capital to limit the procyclical impact
of Basel II and to encourage banks to take a longer perspective.
Goodhart underscored that while IAS will increase transparency,
it will also raise reported volatility as balance sheets are marked-tomarket. What is often overlooked is the interaction between IAS
and Basel II. IAS should improve market discipline under Pillar III
but may be inconsistent with some prudential policies that could
dampen procyclicality. IAS recognizes actual defaults but not
expected losses for accounting purposes, which could shorten the
horizon of banks’ risk management. Specifically, banks only receive
favorable tax treatment on provision made against defaults when
they occur but not on ex-ante provisions made against defaults
expected to occur in a future cyclical downturn.
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Introduction 3
Goodhart emphasized that the impact of Basel II is hard to predict
and may have a limited effect in many countries. Many banks hold
excess capital so the regulatory capital constraint is not binding.
For sophisticated banks, Basel II only brings capital regulation into
line with current capital allocation practices. One concern is that in
emerging markets, Basel II could transfer riskier credits from large
international banks to domestic banks who are less able to manage
them. The former will use the IRB approach and thus will assign
higher risk weights to risky credits than will domestic banks using
the standardized approach.
The discussion of the paper touched on the challenge of determining whether procyclicality is excessive, and when to take preventative actions. In some sense, measuring procyclicality presents
the policy-maker with a moving target given the evolving nature of
business cycles and financial systems. That said, excessive procyclicality can be identified as those fluctuations that cause some combination of unnecessary amplification of the real economy and
damage to the soundness of the financial system. In combating
excessive procyclicality, it was thought that actions are much more
effective and credible when taken during an economic upturn,
when risks are being built up, rather than in a downturn, when the
risks are materializing. More generally, in taking policy decisions
across a range of areas (monetary, prudential, exchange rate), policymakers would need to be mindful of the sources of procyclicality in
their financial systems.
Asian experiences with procyclicality
In his presentation of the IMF paper entitled “Procyclicality in Asian
Financial Systems” (Chapter 3), Stefan Ingves focused on features of
Asian financial systems that exacerbate procyclicality. He noted that
procyclicality in Asia has two revealing characteristics: (i) property
prices are strongly correlated with both credit and real GDP growth;
and (ii) it is highly asymmetric. The latter shows that downturns are
much sharper, reflecting the role of financial crises in driving excessive procyclicality. Empirical evidence showing that large deviations
of asset prices and credit from trend do help predict crises supports
this interpretation.
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4 Procyclicality of Financial Systems in Asia