Special Topics in Financial Stability Analysis

This section deals with selected topics in financial stability, namely,

• The analysis of international financial centers and offshore financial centers and of financial stability

• Key stability issues in the opening of capital accounts

• The implications of dollarization for stability

• Implications of Islamic banking

This list is not an exhaustive list of financial sector issues; it is a list of several issues that are not common to all financial systems and, consequently, were not fully addressed in the general sections, but they are still important in several financial systems.

3.5.1 International Financial Centers and Offshore Financial Centers

International Financial Centers (IFCs) are the primary markets where finance capital and currency are collected, switched, disbursed, and exchanged on a regional or global basis.29 An IFC’s share in the global financial business is disproportionately large relative to its size as measured by area, population, or nonfinancial economic activity. In most rankings, London, New York, and Tokyo (in this order) are the world’s three primary IFCs. They are complemented by a range of secondary and tertiary IFCs, which play important roles as regional financial centers or as major offshore financial centers (OFCs). Although IFCs and OFCs are quite distinct in terms of scale and structure, they are treated together in this section for convenience because they have in common certain stability issues that arise as a result of their international operations.

Although there is no generally approved definition of an OFC, a useful one defines it as a center where the bulk of financial sector activity is offshore on both sides of the balance sheet (that is, the counterparties of the majority of the financial institution’s liabilities and assets are nonresidents), where the transactions are initiated elsewhere, and where the majority of the institutions involved are controlled by nonresidents. Thus, OFCs are usually referred to in the following ways (the third listed is the most popular): [1]

the credibility of government policies, and (d) the creditworthiness of the financial sector. Important requirements or prerequisites are economically strong and credible banks within a strong legal system, including property rights, contract enforcement, a functional and credible court system, and bankruptcy processes. Although those condi­tions are necessary to become an IFC, they are not necessarily sufficient; there are also various historical and other reasons why certain places have become IFCs. Moreover, any financial center requires a long time to establish itself as an IFC. IFCs typically engage in a variety of onshore and offshore financial activities, including foreign exchange trading such as cash, forward, and swap transactions. IFCs also engage in a wide range of equity and debt securities and derivatives trading on the cash, futures, and options markets, not only in organized exchanges and over-the-counter transactions but also in activities such as money management, payments clearing and settlement, merger and acquisition, and securities underwriting. In some cases, some of this activity is carried on in institutions that are favorably treated for tax and other purposes.

Development of an IFC has several potential benefits for the host economy. There is some evidence in the literature quoted earlier that the large presence of foreign banks in IFCs tends to increase competition. More intensive competition, apart from its static benefits, can also widen the range of financial services available to clients. However, there are also cases of IFCs in jurisdictions where domestic markets have failed to overcome some inherent inefficiencies. An important issue to consider is the competition that is taking place among IFCs. From the viewpoint of global welfare, the competition among countries to host offshore banking can result in a gain to a host center that may represent little net gain overall.

At the same time, the presence of an IFC or OFC may be an additional source of instability for the host economy. Financial surveillance needs to analyze not only the complex structure of the key financial institutions operating in an IFC but also the opera­tions in which those institutions are engaged so people can understand the sources of the risks (which are often outside the host jurisdiction) and the transfers of risks within and from the IFC. The effect on domestic financial stability caused by the presence of an IFC or OFC arises from both macro-channels and structural channels. Financial stability would be affected if the domestic economy were more susceptible to shocks than would otherwise be the case, because a segment of the global or regional financial services that are provided takes place in the domestic economy (through the OFC-IFC transactions). Some of those additional factors affecting financial stability follow:

• Additional cross-border business in an IFC or OFC could add to the demands on domestic clearing and settlement systems.

• The presence of an IFC or OFC may make it easier for domestic residents to invest offshore or for nonresidents to invest in securities or claims issued by domestic residents. This condition may improve liquidity in domestic markets and facilitate technology transfer; it may also facilitate excessive risk taking unless restrained by supervision or market forces.

• The effect on domestic economic activity and employment resulting from the pres­ence of an IFC or OFC could be substantial—as is often the case in many OFCs;

hence, shocks to the volume and stability of IFC operations could affect the domes­tic economy and could indirectly affect domestic financial stability.

• Although foreign institutions operating in an IFC or OFC are supervised by their home regulators, the trading activities among those institutions—particularly in OTC markets occurring in the IFC or OFC—may be largely self-regulated and may call for the involvement of host authorities to achieve stability.

• The global reach, large size, and complexity of transactions of domestic – or foreign – controlled institutions in an IFC or OFC may pose supervisory challenges for both host and home jurisdictions.

The operations of large and complex financial institutions (LCFIs) in an IFC or OFC may have financial stability implications. An LCFI is typically a large player in both wholesale and retail financial markets and has substantial international operations span­ning a number of financial activities. The group is likely to be prominent in the local payments, clearing, and settlements structure. The group is likely to encompass many different legal entities, and the link between those and the group’s internal management structure may appear complicated or even opaque. The group may not have an overall lead supervisor monitoring its activities at an overall level on a consolidated basis. At the host-country level, responsibility for supervision of an LCFI’s local affiliates may reside within a single regulator or several functional regulators. The size of the LCFI and its geographical diversification has the potential to threaten financial stability not only in the IFC but also in several countries and markets. The operations may be of concern not only to its many financial regulators but also to the central banks and insurance or guar­antee agencies. The latter group of institutions, in the event of a crisis, could be involved in providing or facilitating liquidity or other official financial support, either to the LCFI itself or to its local counterparties.30

The assessment and monitoring of offshore financial centers has increased in recent years, in part, because of heightened concerns about consolidated supervision and money laundering and because of the associated emphasis on cross-border cooperation and infor­mation exchange with OFCs.31 The assessment methodology for OFCs places emphasis on fostering compliance with international standards for supervision and financial integrity. Because they reflect the concerns about consolidated supervision and money laundering or terrorist financing, the assessments generally focus on compliance with the supervisory standards in banking and standards for anti-money laundering and for countering the financing of terrorism. In addition, when warranted, the assessments also include securi­ties and insurance supervision.32

Levels of compliance with financial sector standards in OFCs tend to be, on average, higher than in other jurisdictions assessed by the Fund; however, shortcomings remain in the supervisory systems of many of the OFCs. The higher level of financial standards compliance in OFCs reflects, in part, the higher income levels of the OFCs and their concerns to protect their reputation. The shortcomings arise mainly from inadequate resources and expertise in the supervisory agencies located in OFCs with lower per capita income. Those shortcomings are reflected in lower conformity with principles that are concerned with the effectiveness of onsite supervision and in technical areas such as risk management and guidance for financial institutions (IMF 2004c).

The evidence that OFCs pose a risk to financial stability in non-OFC countries is limited. The potential for risk is seen to lie in the following areas:

• Banks have been the most common source of financial instability, and most major OFCs have branches or subsidiaries of globally important banks. Many of those banks are also conglomerates, which pose additional risks. Potential threats to financial instability may increase with weaknesses in consolidated supervision and cross-border consolidated supervision of those institutions.

• The lack of information about the activities booked in OFCs restricts the ability to understand global financial flows and to analyze potential stability effects.

• Hedge funds and reinsurance companies located offshore have the potential to affect stability through their high leverage and exposure to catastrophic events, respectively.

However, an OFC itself may face significant macroeconomic risks, which result from its characteristics as an OFC. Given that financial intermediation in the OFC is typi­cally out of proportion with the size of the domestic economy, most OFCs depend on the financial intermediation as a source of income. Shocks to the volume of financial inter­mediation (e. g., those caused by shocks to the reputation of the OFC) are likely to have a substantial effect on the domestic macroeconomy.

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