Tag: IMF

An IMF Working Paper entitled “Islamic Finance, Consumer Protection, and Financial Stability” by Inutu Lukong has been released. This is relevant because Islamic finance is growing rapidly in value and geographical reach. The banking sector is now systemically important in a dozen countries and growing in many other countries.

Consumers of Islamic financial products have increased to critical proportions, thus consumer protection frameworks that cater to the specifics of Islamic financial products should be an integral part of regulatory frameworks in countries where the industry exists. Although still a small share of global finance, Islamic finance is growing rapidly in value and geographical reach. The banking sector is now systemically important in a dozen countries and growing in many other countries. By end December 2013, consumers of Islamic banking products were estimated at 30 million (Enerst and Young (2013)). The Sukuk market has also registered phenomenal growth; the structures have become increasingly complex; and the issuer base has broadened to include advanced, emerging market and developing countries on one hand, and sovereigns and corporates on the other. The growing complexity of products can make it difficult for consumers and investors to discern risks while the broadening of issuers exposes investors to differing counterparty risks.

In the aftermath of the global financial crisis, many countries integrated consumer protection in their regulatory frameworks, but progress has been uneven across countries and few have tailored the frameworks to address the unique risks of Islamic finance. A number of international bodies, including the Islamic Financial Standards Board (IFSB), the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI); and the International Islamic Financial Market (IIFM), have issued standards to cater to the specifics of the Islamic finance industry, but adoption of the standards has been uneven across countries and the development of standards is still evolving.

This paper aims to contribute to ongoing efforts to strengthen the architecture for consumer protection in Islamic finance as part of the broader effort to safeguard the sound development of the sector. Outside the work of the regulatory bodies, research on the protection of consumers of Islamic financial products is limited and remaining gaps in the regulatory architecture for consumer protection in Islamic finance have not been assessed. The few studies on consumer protection in Islamic finance include the paper by Mamhood [2012] which analyzed the prospects of extending an Investor Protection Framework to the Islamic Capital Market in Malaysia; the IFSB [2013] paper that analyzes product regulation that could foster stronger protection for consumers of Islamic financial products; and the IFSB/IOSCO [2013] joint review on issues, risks and challenges arising from potential inadequate disclosure in the areas of Sukuk and Islamic Collective Investment Schemes.

The paper focuses on Islamic banking products and Sukuk, which together account for 95 percent of the Islamic finance industry. It highlights sources of information asymmetries that can result in consumers making uninformed decisions, as well as potential avenues for consumer exploitation in the design of Islamic financial products that could affect the sound development of the industry. It also evaluates the adequacy of current legal and regulatory frameworks for consumer protection, and discusses policy options for strengthening them. The analysis is based on the experiences of a sample of countries, including Bahrain, Egypt, Iran, Jordan, Kuwait, Lebanon, Malaysia, Oman, Qatar, Saudi Arabia, Sudan, the United Arab Emirates, the United Kingdom and Yemen.

The main conclusions of the paper are that Shar’iah principles, which govern Islamic finance, provide a strong foundation for consumer protection, but the features alone cannot guarantee adequate protection for consumers, because not all providers are motivated by ethical precepts, and the practice sometimes deviate from the principles. Consumer protection frameworks for conventional financial products are relevant to Islamic finance, but they need some adaptation to address risks specific to Islamic financial products. In particular, reforms are needed to address consumer vulnerabilities from current practices with respect to Profit Sharing Investment Accounts (PSIA), Ijārah Muntahia Bittamlīk, and conventional deposit insurance schemes as well as to address the legal risks for investors in Sukuk, particularly in cross border default cases.

Note that IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

The IMF released their Regional Economic Outlook for Asia Pacific to April 2015 today. China’s growth is predicted to fall, Australia’s to rise a little, on a comparative basis, our banks hold lower capital than many across the region, and the IMF stress the importance of macroprudential measures to reign in house prices, and fiscal stimulus to support economic growth. A few selected highlights:

Asynchronous monetary policies in major advanced economies in response to divergent cyclical conditions have contributed to large and rapid exchange rate realignments. Robust growth and the prospect of higher interest rates in the United States, coupled with the start of quantitative easing in the euro area and further monetary stimulus in Japan, have caused the value of the major reserve currencies to diverge sharply. While the dollar has gained substantially against most other currencies, rising about 9½ percent on a trade-weighted basis since the end of June 2014, the yen has fallen by about 10½ percent in nominal effective terms over the same period, and the euro has been broadly unchanged.

Against this backdrop, a number of Asia and Pacific currencies have appreciated in nominal effective terms since mid-2014. This reflects somewhat greater stability of Asian currencies relative to the dollar than implied by the share of the United States in these countries’ gross trade. In contrast, the currencies of commodity exporting Australia, Malaysia, and New Zealand have depreciated in nominal effective terms
(Figure 1.7).

Changes in real effective exchange rates have been broadly in line with changes in their nominal counterparts. However, using weights based on domestic value added in exports, appreciations of most Asian currencies have been less pronounced, suggesting a more modest erosion

Bank balance sheets have strengthened across most of Asia. Bank profitability has been high in many countries and, together with injections of new Basel III–compliant equity, has contributed to an increase in Tier 1 capital (Figure 1.23). Note that Australia is at the lower end of Tier 1.

While still outperforming most other large economies, China’s growth rate is expected to continue to edge lower over the medium term as rebalancing proceeds. Growth is projected to ease to 6.8 percent in 2015 and to 6.3 percent in 2016 as the correction in the residential and related sectors continues to drag on investment.

The downturn in the global commodity cycle will continue to affect Australia’s economy, with related investment coming off historic highs. However, supportive monetary policy and a weaker exchange rate will underpin nonresource activity, helping to edge up growth in 2015 to 2.8 percent, rising to 3.2 percent in 2016 (broadly unchanged from projections in the October 2014 WEO).

In Australia and New Zealand, consumers gain from the oil price windfall while forgone mining receipts and royalties have a negative effect on mining companies and the fiscal accounts.

In addition to strong microprudential supervision and regulation, protecting financial stability will require proactive use of macroprudential policies to increase resilience to shocks and contain the buildup of systemic risk associated with changes in financial conditions. In fact, greater reliance on macroprudential policies may be needed where the fi nancial cycle is not well synchronized with the real economy cycle (Australia, Hong Kong SAR, Korea), which may be more likely in the presence of strong unconventional monetary policies in the major economies. To avert overheating or overinvestment in real estate that could threaten the stability of financial systems, eliminating the preferential tax treatment of real estate (for example, by raising taxes on real estate capital gains) and tightening regulations on credit financing for real estate development and purchase (for example, imposing binding loan-to-value limits and debt-service-to-income ceilings) are advised. Macroprudential policies and capital flow measures should not substitute for appropriate macroeconomic policy reactions to volatile capital flows and asset price swings.

On the other hand, fiscal stimulus, or a slower pace of consolidation, may be appropriate for economies facing temporary adverse terms-of-trade shifts or where output is below the full-capacity level (Australia, Korea). But care should be taken to ensure that stimulus is reversed during cyclical upturns and to avoid conflating weaker potential growth with a temporary growth dip.

An IMF working paper published today entitled “High Liquidity Creation and Bank Failures”, suggests that regulators may want to consider incorporating liquidity creation into their early warning systems and subject high liquidity creators to additional oversight to either prevent bank failure or impose an orderly winding-down of the bank and limit taxpayer losses.

Identifying vulnerabilities which may lead to bank failure is a persistent challenge to regulators of financial systems and market analysts. Regulators seek timely warning of bank failures for an efficient deployment of monitoring resources and for enhancing regulation enforcement, and shareholders and taxpayers want to avoid substantial resolution costs as well as reduce the time involved in loss resolution.

Two hypotheses in the literature on bank fragility explain bank failures: the “Weak Fundamentals Hypothesis” (WFH) and the “Liquidity Shortage Hypothesis” (LSH). Under the WFH, poor bank fundamentals foreshadow an impending bank failure and CAMELS components are often used as the basis for an early warning system. Bank failures are thus information-based, as decaying capital ratios, reduced liquidity, deteriorating loan quality, and depleted earnings signal an increased likelihood of bank failure. In contrast, the LSH assumes that banks are solvent institutions but fragility is due to the irrational behavior of uninformed depositors who are unable to distinguish between liquidity and solvency shocks. According to this hypothesis, bank vulnerability to crises stems from the financing of illiquid assets with liquid liabilities. When exposed to an external shock and under the sequential servicing constraint, first-in-line depositors seek to withdraw all their deposits and, as the bank’s ability to meet deposit withdrawals declines, liquidity shortages become pronounced and the probability of failure increases.

The WFH focuses on asset risk to explain bank fragility and bank risk under the LSH arises from the liability side of the balance sheet. In this paper, we propose that bank vulnerability may result from the interaction between both asset and liability risks. Using new measures on liquidity creation, we postulate that banks’ vulnerability to failure may resultfrom a proliferation in the core activity of liquidity creation. We propose the “High Liquidity Creation Hypothesis” (HLCH) to explain bank failures, complementing the WFH (which identifies banks with weak fundamentals) and the LSH (which focuses on the inability of banks to meet liquidity commitments). According to the HLCH, a bank’s vulnerability increases when the core output measured by liquidity creation reaches high levels compared to other banks’ activities in the system.

To test this, we need a banking system that witnessed a number of bank failures which are unrelated to economic business cycles or triggered by adverse exogenous shocks. In Russia, over 200 banks failed between 2000 and 2007 and many of those failures were not associated with the business cycle. Thus, the banking system in Russia provides a natural field experiment to test as we are able to isolate the reasons for bank fragility independently from exogenous events.

To gauge the impact of high liquidity creation on the probability of bank failures, we perform logit regressions with bank random effects. We use different thresholds to define high liquidity creation in a given quarter, based on the distribution of the entire liquidity creation in the banking system. Our findings confirm the hypothesis that high liquidity creation increases the probability of bank failure, and the results are robust to several validity checks. Rather than suggesting an absolute cut-off value, we propose to screen financial intermediaries based on their liquidity creation ranking in the system. The identification of high liquidity creators allows regulators to at least place these banks on the watch list for enhanced oversight in view of reducing the number of failures in the system and strengthening incumbent institutions.

We propose a screening procedure of banks, ranking them based on their liquidity creation in the system. Specifically, we define high liquidity creators as banks with a liquidity creation level in a given quarter that exceeds the 90th percentile of the distribution. When liquidity creation becomes high, the probability of failure for such a bank increases significantly more than for other banks. Our results are robust to alternative measures of liquidity creation and definitions of bank failure, and controlling for bank location, market concentration, and regulatory changes. They are also in line with the theoretical predictions of Allen and Gale (2004) and empirical results for the U.S. (Berger and Bouwman, 2011).

The HLCH has two main implications. First, it suggests that liquidity creation by banks can be counterproductive when it becomes high. Liquidity creation above a certain threshold increases the probability of bank failure, eventually leading to the disappearance of the high liquidity-creating institution and even a reduction in the volume of aggregate liquidity creation in the economy. Therefore, regulatory authorities may need to give more attention to the liquidity-creating activities by banks when identifying vulnerabilities in the financial system. Second, our main finding provides insight for regulatory authorities to predict bank failures. Specifically, regulators may want to consider incorporating liquidity creation into their early warning systems and subject high liquidity creators to additional oversight to either prevent bank failure or impose an orderly winding-down of the bank and limit taxpayer losses.

An IMF Working Paper was released today, entitled “Does Basel Compliance Matter for Bank Performance?”.  They conclude that overall Basel compliance has no association with bank efficiency. This is important because the burden of compliance with international regulatory standards is becoming increasingly onerous, and financial institutions worldwide are developing compliance frameworks to enable management to meet more stringent regulatory standards. As regulators refine and improve their approach and methodologies, banks must respond to more stringent compliance requirements. This has implications for risk management and resource allocation, and, ultimately, on bank performance.

However, there is no evidence that any common set of best practices is universally appropriate for promoting well-functioning banks. Regulatory structures that will succeed in some countries may not constitute best practice in other countries that have different institutional settings. There is no broad cross-country evidence as to which of the many different regulations and supervisory practices employed around the world work best. As a consequence, the question of how regulation affects bank performance remains unanswered. Regulators around the world are still grappling with the question of what constitutes good regulation and which regulatory reforms they should undertake.

The global financial crisis underscored the importance of regulation and supervision to a well-functioning banking system that efficiently channels financial resources into investment. In this paper, we contribute to the ongoing policy debate by assessing whether compliance with international regulatory standards and protocols enhances bank operating efficiency. We focus specifically on the adoption of international capital standards and the Basel Core Principles for Effective Bank Supervision (BCP). The relationship between bank efficiency and regulatory compliance is investigated using the (Simar and Wilson 2007) double bootstrapping approach on an international sample of publicly listed banks. Our results indicate that overall BCP compliance, or indeed compliance with any of its individual chapters, has no association with bank efficiency.

From a theoretical perspective, scholars’ predictions as to the effects of regulation and supervision on bank performance are conflicting. The greater part of policy literature on financial regulation has been inspired by the broader debate on the role of government in the economy. The two best-known opposing camps in this field are the public interest and the private interest defenders, who both, nonetheless, agree on the assumption of market failure. For the public interest camp, governments regulate banks to ensure better functioning and thus more efficient banks, ultimately for the benefit of the economy and the society. For the private interest camp, regulation is a product of an interaction between supply; it is thus the outcome of private interests who use the coercive power of the state to extract rents at the expense of other groups.

According to the public interest view, which largely dominated thinking during the 20th century, regulators have sufficient information and enforcement powers to promote the public interest. In this setting, well-conceived regulation can exert a positive effect on firm behavior by fostering competition and encouraging effective governance in the sector. In contrast, according to the private interest view, efficiency may be distorted because firms are constrained to channel resources to special-interest groups. This implies that regulation may not play a role in improving bank efficiency. Kane (1977) suggested that these conflicting views help frame the complex motivations underlying regulatory policies. He argues that officials are subject to pressures to respond to both public and private interests, and that the outcome of such an oscillation depends on incentives. Swings in the approach to regulation reflect the interplay of industry and political forces and the occurrence of exogenous shocks (crises for example). These complex interactions may have conflicting effects on the efficiency of the banking system.

We focus on the adoption of international capital standards and the Basel Core Principles for Effective Bank Supervision (BCP). These principles, issued in 1997 by the Basel Committee on Bank Supervision, have since become the global standards for bank regulation, widely adopted by regulators in developed and developing countries. The severity of the 2007–09 financial crisis has cast doubt on the effectiveness of these global standards; regulatory reforms are under way in several countries. The initial crisis-induced assessment of regulatory failure is now giving way to a more complex regulatory dialogue and detailed evaluation of the principles underlying international regulatory standards as well as the implications of their adoption, in terms of banks’ safety and soundness. In addition, the burden of compliance with international regulatory standards is becoming increasingly onerous, and financial institutions worldwide are developing compliance frameworks to enable management to meet more stringent regulatory standards. As regulators refine and improve their approach and methodologies, banks must respond to more stringent compliance requirements. This has implications for risk management and resource allocation, and, ultimately, on bank performance.

On the regulators’ side, excessive reliance on systematic adherence to a checklist of regulations and supervisory practices might hamper regulators’ monitoring efforts and prevent a deeper understanding of banks’ risk-taking. More specifically, to shed some light on the aforementioned issues, we aim to answer the following questions: (i) Does compliance with international regulatory standards affect bank operating efficiency? (ii) By what mechanisms does regulatory compliance affect bank performance? (iii) To what extent do bank-specific and country-specific characteristics soften or amplify the impact of regulatory compliance on bank performance? (iv) Does the impact of regulatory compliance increase with level of development?

Building on the IMF and the World Bank Basel Core Principles for Effective Bank Supervision (BCP) assessments conducted from 1999 to 2010, we evaluate how compliance with BCP affects bank performance for a sample of 863 publicly listed banks drawn from a broad cross-section of countries. We focus on publicly listed banks, on the assumption that these institutions are subject to more stringent regulatory controls and compliance requirements. This focus should also enhance cross-country comparability because these banks share internationally adopted accounting standards. Further, we categorize the sample countries by both economic development and geographic region.

Our results indicate that overall BCP compliance, or indeed compliance with any of its individual chapters, has no association with bank efficiency. This result holds after controlling for bank-specific characteristics, the macroeconomic environment, institutional quality, and the existing regulatory framework, and adds further support to the argument that although compliance has little effect on bank efficiency, increasing regulatory constraints may prevent banks from efficiently allocating resources. When only banks in emerging market and developing countries are considered, we find some evidence of a negative relation with specific chapters that relate to the effectiveness of the existing supervisory framework and the ability of supervisors to carry out their duties. However, these results need to be treated with caution, because they may also reflect the inability of assessors to provide a consistent cross-country evaluation of effective banking regulation.

The latest edition of the IMF’s World Economic Outlook, just released, portrays a complex global picture. There are several points relevant to Australia, in the pre-budget run-up.

• Legacies of both the financial and the euro area crises are still visible in many countries. To varying degrees, weak banks and high levels of debt—public, corporate, or household—still weigh on spending and growth. Low growth, in turn, makes deleveraging a slow process. Potential output growth has declined. Potential growth in advanced economies was already declining before the crisis. Aging, together with a slowdown in total productivity, has been at work. The crisis made it worse, with the large decrease in investment leading to even lower capital growth. As we exit from the crisis, capital growth will recover, but aging and weak productivity growth will continue to weigh. The effects are even more pronounced in emerging markets, where aging, lower capital accumulation, and lower productivity growth are combining to significantly lower potential growth in the future. More subdued prospects lead, in turn, to lower spending and lower growth today.
• On top of these two underlying forces, the current scene is dominated by two factors that both have major distributional implications, namely, the decline in the price of oil and large exchange rate movements.
• Australia’s projected growth of 2.8 percent in 2015 is broadly unchanged from the October prediction of 2.7 percent, as lower commodity prices and resource-related investment are offset by supportive monetary policy and a somewhat weaker exchange rate. 3.2 percent growth is forecast for 2016, supported by low interest rates and inflation.
• The downturn in the global commodity cycle is continuing to hit Australia’s economy, exacerbating the long-anticipated decline in resource-related investment. However, supportive monetary policy and a somewhat weaker exchange rate will underpin nonresource activity, with growth gradually rising in 2015–16 to about 3 percent.
• Average annual metal prices are expected to decline 17 percent in 2015, largely on account of the decreases in the second half of 2014, and then fall slightly in 2016. Subsequently, prices are expected to broadly stabilize as markets rebalance, mainly from the supply side. The largest price decline in 2015 is expected for iron ore, which has seen the greatest increase in production capacity from Australia and Brazil.
• Exporters of commodities (Australia, Indonesia, Malaysia, New Zealand) will see a drop in foreign earnings and a drag on growth, although currency depreciation will offer some cushion.
• Australian unemployment, net is forecast at 6.4 percent in 2015.
• In addition to strong regulation and supervision, protecting financial stability may also require proactive use of macroprudential policies to tame the effects of the financial cycle on asset prices, credit, and aggregate demand.

The IMF just published a discussion paper looking at what happened in Spain, Ireland, US and Iceland after the 2007 crash. In some countries, as house prices fell (some as much a 50%) creating an negative equity situation, the main response was a default sale, whereas elsewhere other strategies were tried, sometimes with government assistance or intervention. With the benefit of hindsight, it appears that loan modification or restructuring offered the best path to economic recovery and provided better outcomes for individual households. Worth noting when the Aussie housing market finally turns!

A number of interesting variations to loan modification were found in the research:

Trial modification – A trial period allows borrowers to showcase their debt service commitment and provides time to further calibrate the efficiency of the loan modification terms, in particular when the recovery is ongoing. In the US, HAMP requires borrowers to enter into a 90-day Trial Period Plan, during which a Net Present Value test is carried out to determine whether the borrower can be offered a permanent loan modification.

Split mortgage – A split mortgage divides the original principal into a part that continues to be serviced in full and a warehoused part that falls due at a later time. The warehoused part may be charged interest. At maturity, this portion may be refinanced, repaid if borrower circumstances allow, paid off from the sale of the home, or written off.

Shared appreciation – A shared appreciation modification reduces the outstanding balance on a mortgage until the borrower is no longer underwater, while entitling the lender to a portion of any home price gain once the home is sold.

Earned principal forgiveness – Arrears or principal forgiveness necessary to ensure long term sustainability may be granted to borrowers that remain in good standing on their mortgage payments. In Ireland and the US, earned principal forgiveness schemes forebear interest on a portion of the loan which may subsequently be forgiven if the borrowers remain current on all debt service obligations.

Negative equity transfer – Products allowing the transfer of negative equity to a new mortgage give mortgagees in negative equity the opportunity to benefit from refinancing at lower rates or move to smaller homes, which may improve their overall debt servicing capacity.

Debt overhang in the aftermath of a systemic housing crisis can cause a weak and protracted recovery. The effects of debt overhang from excessive debt payment burdens or declines in household wealth can create negative feedback effects that hamper the recovery and increase the cost of a crisis. As in other downturns, monetary policy and social safety nets provide a first line of defense. In addition, policies that temporarily allow forbearance of lenders vis-à-vis borrowers and facilitate the modification of distressed mortgages can help to contain the undershooting of house prices by reducing the extent of foreclosure and associated deadweight losses and social costs. Systemic crises can affect the trade-offs involved in these policy choices and warrant policies that deviate from “normal” times. However, different country circumstances suggest there cannot be a “one-size-fits-all” approach, and policy formulation should take into account important country specific factors as well as the stage of the recovery.

Temporary forbearance offers breathing space during a crisis, but should be selective and time-bound. Forbearance can reduce household financial distress in the short run, helping households to adjust their consumption more smoothly. However, temporary forbearance can induce free riding and should only be considered in cases of sufficiently strong prospects for a recovery of the borrower’s debt service capacity. While forbearance can help to act as a circuit breaker at the peak of the crisis, it is important that lenders remain selective in granting forbearance and reach formal forbearance agreements in order to avoid an erosion of the debt service culture and to ensure that borrowers remain engaged. Temporary forbearance can also tie in with loan modification by serving as a “trial modification” and bridging a period of elevated uncertainty about future incomes and house prices.

Systemic housing crises can tilt workout choices from foreclosure towards loan modification. Foreclosures are costly and can have negative externalities on house prices. Negative equity and prospects for the recovery of borrowers’ income suggest that loan modification becomes a net present value efficient solution for a larger share of delinquent borrowers. However, renegotiation cost and other obstacles often obstruct loan modification.

Policies can help to facilitate loan modification. Frameworks for orderly debt renegotiation in form of a code of conduct for lenders dealing with distressed borrowers, together with an efficient statutory framework for personal insolvency, can shape expectations and improve coordination, thereby facilitating timely loan modification. Prudential policies can set appropriate incentives to encourage loan modifications and facilitate the use of innovative modification techniques. A temporary tax exemption could help to enable loan principal relief. Depending on the availability of fiscal resources, support could be provided for mortgage counseling and targeted incentive payments could promote loan modifications. However, experience from Ireland and the US shows that even with such policies, a significant number of mortgages can remain unsustainable and require foreclosure.

Efficient foreclosure procedures provide a resolution of last resort and an important incentive for constructive borrower behavior. In cases where constructive cooperation between borrowers and lenders breaks down, or where no sustainable loan modification would be net present value optimal, foreclosure must remain as last resort. Delays in foreclosure procedures have been found to increase defaults and overall workout costs. Instead, a temporary increase in foreclosure costs through fees or taxes could reduce lenders’ reliance on foreclosure as workout tool. To avoid a deterioration of credit service culture, protections from foreclosure should only be extended to cases where other solutions are likely sustainable (with exceptions for hardship cases), and a foreclosure threat needs to remain present to deter strategic borrower behavior.

Across-the-board debt relief is costly and may require intrusive government intervention. Across-the-board debt relief is sometimes considered as crisis measure as it can be implemented quickly and provides immediate relief to many mortgagees. However, the macroeconomic benefit of a broad-based debt reduction tends to be small relative to its cost, and blanket debt reductions are not well targeted to address debt servicing difficulties. Implementing across-the-board debt relief can also have negative ramifications for the supply of mortgage credit in the long run.