Y V Reddy: Issues in implementing international financial standards and codes
Public lecture by Dr Y V Reddy, Deputy Governor of the Reserve Bank of India, at the Centre for
Banking Studies of the Central Bank of Sri Lanka, Colombo, 28 June 2001.
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Governor Jayawardena, Deputy Governor Wijewardena and friends,
It gives me great pleasure to deliver this public lecture at the Centre for Banking Studies (CBS) of the
Central Bank of Sri Lanka. It gives me greater pleasure to share the podium with Governor
Jayawardena whom I greatly admire for his intellect, acumen and outstanding statesmanship. The last
time I shared the same forum with him was at the Second South Asia Forex Dealers' Association
Conference at Hyderabad in October 1998. The East Asian countries were still in the midst of crisis. I
remember that he had listed do's and don'ts of policy making for crisis avoidance, and his words of
wisdom continue to be valid even today.
Since both Sri Lanka and India shared many concerns in this regard, Governor Jalan had in August
1999 devoted the 49th Anniversary Lecture at the Central Bank of Sri Lanka to the subject of
international financial architecture (Jalan, 1999). Reflecting on the developing countries perspectives,
he focused on several areas of significance, viz., the exchange rate, the policy on reserves, the role of
the external private sector, the management of capital flows, strengthening the financial system,
transparency in systems and development of standards and codes, reform of international institutions
and new arrangements for international liquidity. In particular, Governor Jalan flagged several issues
relating to transparency in systems and developing standards and codes, and today I propose to
highlight aspects relating to implementation of these standards and codes.
There are several reasons for choosing to speak on this subject today. Among all the issues posed by
Governor Jalan in his Colombo speech, noteworthy progress is noticeable in respect of standards and
codes. Furthermore, the basic parameters on the issue of codes enunciated by him stand vindicated
by subsequent events. Moreover, India has gained some experience in sensitising the issues and
creating an awareness, and in attempting self-assessment of its own adherence to various standards
and codes benchmarked against international norms.
Finally, issues relating to financial stability have gained significant attention of policy making in recent
years. In fact, Mr. Andrew Crockett, General Manager, Bank for International Settlements had made
an outstanding analysis of "Why is Financial Stability a Goal of Public Policy" (1997) in the Jackson
Hole (Wyoming; U.S.A.) Conference of August 1997 in which I had participated. More importantly, he
has through the Financial Stability Forum, brought about a more participative approach to evolution,
consolidation and implementation of international standards and codes, though these initiatives need
much more progress. A description of the key standards and the monitoring of their observance is
available on the publication of Financial Stability Forum (April 2001) http://www.fsforum.org entitled
"International Standards and Codes to Strengthen Financial Systems" and so I will not spend time
giving a descriptive account of them.
Standards and codes: current international context
The development of international standards and codes in the current context has five important
features, viz., it is part of the reform of the international financial architecture; it represents a
consolidated view of several interrelated standards and codes; it is a collaborative effort involving
different groups of countries, markets and international financial institutions and standard setting
agencies and bodies; it has elements of both external and internal assessments of degree of
compliance; and, finally there is an assumption of linkage between the implementation of standards
and codes and financial stability.
First, in the light of the Asian crisis, the need for fundamental changes in the international financial
architecture acquired greater urgency. Many proposals were made for strengthening the international
financial system. The focus of these proposals was broadly on indentifying indicators of financial
vulnerability, development of sound international codes, standards and best practices, introduction of
preemptive measures and safety nets, and designing a framework for crisis management. Thus, while
development of international standards and codes is only one element of the overall effort in the
aftermath of the Asian crisis to reform the international financial architecture, significant progress is
noticeable in this element only. As part of the effort to strengthen financial systems and improve
coordination among the agencies responsible for them, the Financial Stability Forum (FSF) was
established in April 1999. Its mandate is to promote international financial stability by improving the
functioning of markets and reducing systemic risk through information exchange and international
cooperation in supervision and surveillance of financial markets. The FSF has drawn together various
standard-setting bodies which were constituted by means of cooperation among central banks,
international financial institutions, national authorities and international supervisory and regulatory
bodies. The FSF has posted on its website the Compendium of Standards, which serves as a
common reference for various standards. Currently, there are 69 standards cited in the Compendium.
A set of 12 standards has been highlighted by the FSF as key for sound financial systems and
deserving of consideration for priority implementation. The key standards are broadly accepted as
representing minimum requirements for good practice. The 12 key areas are organised under three
broad headings, viz., macroeconomic policy and data transparency (covering monetary and financial
policy transparency, fiscal policy transparency, data dissemination and data compilation), institutional
and market infrastructure (covering insolvency, corporate governance, accounting, auditing, payment
and settlement and market integrity) and financial regulation and supervision (covering banking
supervision, securities regulation, and insurance supervision).
Second, the current initiative represents a consolidated view of several interrelated standards and
codes. The international standard-setting bodies have existed for a long time, but each body was
developing common codes and rules in isolation. There are various international organizations, which
over the years have made significant contribution to raising standards of soundness and
riskawareness in financial systems. After the Asian crisis, it was recognised that the world economy can
be exposed to potential threat of contagion from problems in financial markets and so it became
imperative to strengthen financial systems through intensified coordination and cooperation among
national regulatory bodies, international regulatory bodies and international financial institutions
charged with fostering standards and codes. For the first time, a consolidated view of several
standards broadly relevant to the financial sector was considered essential on an appreciation of their
inter-linkages. For example, macro economic policy can affect the sectoral dimension of financial
stability through its impact on the value of financial assets and liabilities. More important, it can affect
the functioning of the payments and settlement systems. Similarly, regulation and supervision are
linked to good accounting practices, bankruptcy laws and insolvency procedures, and corporate
governance principles.
Third, the current process is a collaborative effort involving developed countries and emerging
economies, international institutions, public and private sector and regulators and market participants.
The emphasis has been concentrated on the official sector, with the responsibility for implementation
and accountability for results being vested with the Government or the regulatory agency. It is now
being recognised that the percolation of the compliance to certain standards and codes by the official
sector will depend upon improvements in the private sector also. For instance, while banking
supervision/regulatory practices by official authorities would improve significantly by adhering to the
core principles, in a market related environment, the overall efficiency of the system cannot be
enhanced without adequate response from the banking institutions themselves. Similarly, corporate
governance in banking and also in the private corporate sector, in particular in securities firms would
be an important aspect.
Fourth, the current initiative has elements of external assessment and incentive for internal
assessment of degree of compliance of a country with the key standards and codes. Thus, the IMF
and the World Bank have developed an organisational framework for assessing member countries'
observance of standards and codes. The IMF assesses the implementation of standards as part of its
Article-IV consultations and the Financial Sector Stability Assessment (FSSA) discussion processes in
several countries and the assessments are documented in the Reports on Observance of Standards
and Codes (ROSC). The IMF is preparing ROSCs on data dissemination and fiscal transparency,
which are considered to be areas important to its mandate of overseeing international monetary and
financial stability. The World Bank is producing ROSCs on auditing, corporate governance, and
insolvency and credit rights systems. In preparing the ROSCs, the assessments have generally been
sensitive to different stages of economic development, administrative capacities and heterogeneous
cultural, legal and institutional conditions of Fund members. Participation in ROSC, however,
continues to be voluntary in nature. Internal assessments are also encouraged by international
institutions and standard setting bodies.
Fifth, the entire exercise relating to the international standards and codes is being undertaken on the
premise that their implementation helps to promote sound financial systems domestically enabling
their smooth integration to global markets contributing thereby to financial stability internationally. They
are meant to play an important role in strengthening financial regulation and supervision, enhancing
transparency, facilitating institutional development and reducing vulnerabilities. Standards are also
expected to facilitate informed decision making in lending and investment and improve market integrity
and, thereby, minimize the risks of financial distress and contagion. No doubt, standards are not ends
in themselves but a means for promoting sound financial fundamentals and sustained economic
growth.
Assessment of international initiative
It may be useful to assess the response to these international initiatives in terms of the validity of the
approach, adequacy of coverage of issues, symmetry of treatment between participants, linkage
between international standards and codes and financial stability and issues of coverage of standards
in IMF surveillance.
First, the latest Trade and Development Report (UNCTAD, TDR, 2001) questions the validity of the
overall approach to the reform of the international financial architecture. It observes that the recent
efforts have focussed on measures mainly designed to discipline debtor countries. While it is
conceded that all the reforms that are being prescribed have their merits, there is an overriding
presumption in the prescriptions that the causes of the crisis rests primarily with policy and institutional
weaknesses in the debtor countries and hence place the onus of responsibility of reform on the
debtors. The Report observes that inadequate attention has been given to the role of institutions and
policies of creditor countries. The root of the problem, according to UNCTAD, lies in the failure to
establish a stable exchange rate system. There are also criticisms that although the IMF introduced
the contingent credit lines, it has not been used so far. It is well recognised that the capacity of the IMF
to raise resources is severely limited and is inadequate compared to the size of the recent financial
packages. There are also views that not much has been done on standstill arrangements and
bankruptcy procedures.
Secondly, there are varying perceptions among different actors resulting in inadequate attention to
many aspects of international order. A study by Prof. Stephany Griffith Jones (2001) highlights that all
key actors involved in the reform process, viz., developed country Governments, banking and financial
markets and international financial institutions share one common objective, which is, that they are in
favour of and benefit from sustained growth of developing countries. For some (developing countries
and international financial institutions) it is a dominant objective. There is, however, far less agreement
on specific measures to be taken for building a new international financial architecture. An important
example relates to the opening of the capital accounts by developing countries. While international
financial markets have a strong preference for full opening up, most developing countries favour a
gradual and sequenced opening up. The study also observes the attitudes of the different players on
specific changes in the international financial architecture. The areas include codes and standards,
international liquidity, development finance, international regulation, standstill and orderly debt
workouts and increased developing country participation. The matrix shows that except in the area of
standards and codes, most of the significant measures that would need to be taken have not actually
happened.
Thirdly, it is argued that the progress made so far reflects asymmetry in different participants'
responsibilities for the changes required. The main criticism is that it does not adequately address the
concerns of developing countries. The obligations contained in the standards and codes seem to
reflect the view that the main flaws in the system for international capital movements are to be found in
recipient countries which should thus bear the burden of adjustment needed to prevent or contain
financial crisis. The UNCTAD Report (2001) states: "the reform process rather than focussing on
international action to address systemic instability and risks has placed emphasis on what should be
done by national institutions and mechanisms. Even in this regard it has failed to adopt an
evenhanded approach between debtors and creditors. Thus, it seems as if standards and codes are
being pressed upon developing countries to improve transparency and disclosure without
corresponding obligations for disclosure by financial institutions and hedge funds". I may, however,
add that this conclusion does not in any way minimise the importance of standards to any nation. It
would be preferable to move to best practices irrespective of other country practices.
Fourthly, the link between implementation of standards and codes and financial stability by itself is
neither theoretically established nor backed by sufficient empirical evidence though on the basis of
first principles and judgment, the linkage between the two elements is apparent. Financial stability
requires stability of both financial institutions and financial markets (Vasudevan 2001). The stability of
financial institutions depends on the confidence of public regarding the ability of the former to meet
contractual obligations. Standards relating to effective banking supervision, for example, aim at
enhancing stability of the institutions. Stability in financial markets is reflected in market participants'
confidence at being able to transact at prices reflecting true market fundamentals. Standards on
accounting, auditing, data dissemination, and securities settlements systems, in turn, aim at
strengthening stability of financial markets. The standards and codes, however, do not address the
problem associated with inability of the market agents to understand and process the information. In a
vast majority of developing countries, and possibly in developed countries as well, as the recent large
corrections in the international stock markets suggest, mispricing of information could often give rise to
instability. There are some markets, which tend to move more by noise and rumours than news. In
such markets, release of additional information may not be recognized and understood by the players
and may add more noise than information. Thus, in developing countries, it can be argued that
information superiority of the regulator or Government may be justified when it shoulders the dual
responsibility of both "market development" and "avoidance of market failure".
As regards institutional stability, compliance with related standards appears to make a positive
contribution since the early warning indicators that could be compiled due to implementation of the
relevant standards, could potentially contain the probability and severity of a crisis provided timely
action is initiated at the early sign of vulnerability. Stronger and sound supervision of institutions in
respect of compliance with related standards, while strengthening the preventive mechanisms and
leading to timely and proactive interventions, may not fully insulate the system from occurrence of
financial frauds.
A difficult issue that needs to be addressed while implementing standards and codes for strengthening
stability of institutions is that the implementation of standards enables compilation and monitoring of
information both on aggregated information across all financial institutions and on systemically
important individual institutions. The implementation authorities should recognise the value and
usefulness of both segregated and aggregated data and information and imbibe analytical skills and
techniques to draw useful conclusions.
Recent initiatives on Macro-Prudential Indicators (MPIs) aim at addressing this particular issue of a
macro-view. Aggregation of performance indicators across heterogeneous groups like banks,
nonbanks, development banks, merchant banks, securities firms, insurance companies etc., however,
may not always convey any meaningful signal. In bank dominated financial systems, the emphasis,
therefore, has been on aggregating the information first across banks, then extending it to other
institutions over time. Monitoring is also exercised over different groups separately at group level.
Group level analysis that clearly tracks inter-group exposures partly addresses the problem of
aggregation for the system as a whole.
Fifthly, despite the apparent emphasis on their voluntary adoption, there is a danger that incentives
and sanctions linked to standard setting will become features of IMF surveillance and conditionality. In
such a scenario, publication of information on the compliance status, particularly the information
presented in the ROSC reports, is fraught with the danger of classifying the countries into performers
and non-performers. Even when the international agencies associated with the work on standards and
codes may not intend so, once the information is disseminated, it is possible that credit rating
agencies may assign country ratings on the basis of the levels of achievement of standards. Internal
assessments and external evaluations under Article-IV and FSAP by the Fund-Bank have, therefore,
to be extremely cautious about the dissemination of information on a country's compliance status. The
policy makers, who shoulder the responsibility for developing markets while at the same time avoiding
market instabilities must retain full discretion on their own dissemination policy.
Desirable approach at national level
Briefly stated, the recent international initiatives in regard to standards and codes provide at best a
partial solution to the problems of existing international financial architecture. Furthermore, in the
context of a crisis, they provide solutions at domestic level for issues that may often originate outside
the country. Finally, they do not assure international financial stability although they may contribute to
it. Yet, there are several reasons why public policy and national authorities need to focus on the
international standards and codes and these reasons centre around both efficiency and stability of
financial sector in the country. In this context, a desirable approach to the consideration of
international standards and codes can be explored in national interest.
As mentioned earlier, standards are not totally new. The current international effort is only to codify
best practices and disseminate widely to member countries so that the domestic markets in a
globalised environment will grow and integrate in harmony without destabilisation. The role of financial
sector as also the other institutional arrangements for efficient economic activity has been extensively
debated in the past. One issue is whether the market behaviour has to be viewed from a normative
angle passing 'value judgments' or the market behaviour should be taken as 'rational' or 'commercial'
behaviour. This leads to the wider debate between State versus Market and the role of the regulator
over markets. History has taught lessons that while markets have a key role to play, there are limits to
market behaviour leading at times to crisis situation. It is necessary to recognize that just as the nature
and functioning of 'State' has some variations as between countries, the working of markets also
varies among countries.
When a country gets globalised, the domestic institutional, legal and other structures have to be in
reasonable harmony with international best practices. Otherwise, international flows cannot freely
respond to market signals and information. Therefore, the risks arising in domestic markets can spill
over as international or cross border risks. It is in the light of the increasing global cross border flows
and handling of risks arising thereby, that the acceptance and adherence of international best
practices assume significance. While the standards and best practices may not uniformly apply and
the relevance and applicability may differ from country to country, as a medium and longer term
endeavour, development of international best practices in any country may be viewed in the best
interest of sound, stable and efficient financial structure.
Although the standards have evolved in the context of international stability, they have enormous
efficiency-enhancing value by themselves. Standards by themselves may be presumed to be, prima
facie, desirable, and it is, therefore, in the national interest to develop institutional mechanisms for
consideration of international standards. Thus, the implementation of standards needs to be given a
domestic focus with the objectives of market development and enhancing domestic market efficiency.
Some standards keep evolving and it is important to keep close track of development in these areas. It
also needs to be recognized that the process is evolutionary and say two years down the line, present
standards themselves can change, in degree and detail though not in kind.
In a broad sense, it can be held that all standards are, in some way or other, relevant for all the
countries though the extent of relevance, scope for application and urgency of implementation may
differ depending upon the stage of development as also the country specific, legal and institutional
structures. In particular, in economies which do not have developed markets, the entire market
development has to be given greater weight than mere application of standards. In the case of such
economies, the advantage is that since they are starting on a clean slate, the standards and best
practices could be easily incorporated as they go along with the development of institutions and
markets.
While there can be no uniform prioritisation of standards relevant for all countries, it is possible to
place, on a universal basis considerable emphasis upon certain specific areas depending on individual
country circumstances. To quote the Task Force on Implementation of Standards chaired by Andrew
Sheng (2000) : "prioritization of standards for implementation must necessarily vary from economy to
economy, taking into consideration their current status in observance of standards, economic
circumstances, financial structures, legal and institutional frameworks, and policy priorities. A balance
would need to be struck between international and domestic considerations".
It would be useful to explore parameters for prioritization in respect of specific countries though there
could be different approaches. For instance, it would be easier to implement standards in areas, which
have been substantially developed. On the contrary, the prioritization for a particular country could
consider the identification of 'weak areas'. The weak areas may be, for example, weak legal base
leading to legal uncertainties, lack of regulation leading to lack of regulatory norms, etc.
It may also be possible to classify the standards in a conceptual framework under three broad
elements, viz., technical, policy and socio-cultural. Standards like SDDS, accounting and auditing, and
supervision may be classified as purely technical and, therefore, easily amenable to implementation.
Standards on monetary and financial policies, fiscal transparency and securities regulation have
certain policy implications and would form an integral part of the economic reform process in many
developing countries. The changes in these areas depend on timing, sequencing and complementarity
in related areas and availability of institutional, technological and legal infrastructure. Nevertheless,
while it is desirable to adopt these standards quickly, it actually boils down to an issue of managing of
policy reforms in a non-disruptive fashion. Finally, standards in the areas of corporate governance,
insurance and to a certain extent insolvency and bankruptcy practices take a socio-cultural dimension
and pose challenges of design, adoption and implementation.
It is also possible to attempt a construct of the link between transparency and macroeconomic policy.
Good macroeconomic policy and good standards is perhaps an ideal situation for a country. Good
macroeconomic policy and poor transparency though not ideal is perhaps not risky by itself. Bad
macroeconomic policy and good transparency has large elements of risk and warrants change in
policy before launching into transparency. The most risky combination perhaps is bad macroeconomic
policy and bad standards. In a more dynamic sense, it can be argued that transparency provides
incentives to adopt good macroeconomic policies.
Practical issues in implementation
It is difficult to attempt an exhaustive or universally applicable account of practical issues in
implementation of standards and codes since they are country-specific. It is, however, worth exploring,
albeit hesitatingly, some general observations.
First, while transparency and financial stability appear fundamentally complementary, there could be a
trade off at some point. Therefore, codes should be treated as milestones and the exact manner and
timing of dissemination of information including the structure of reporting should depend not only on
constitutional, legal and institutional mechanisms but also the likely impact of dissemination on the
financial sector soundness and stability in a given context.
Secondly, many codes emphasise legislative provisions in a concrete manner. Legislation provides
the shield or back up for such actions. The emphasis of the codes should be to promote a general
effort to improve legislative provisions and it is necessary to recognise that the process of legislation is
time consuming and complex. While it is essential to recognize the importance of legislation, given its
complexity, we need to appreciate that sound practices also could be as satisfactory.
Thirdly, the implementation of monetary policy is centralised with a single authority, generally the
central bank, while the implementation of financial policies pertaining to various sectors like non-bank
financial institutions, insurance, securities markets and payments and settlement may rest with
different institutions. While the standards and codes could be taken as umbrella ones for all
institutions, different aspects of implementation have to be dealt with separately for different sectors.
This is necessary because the objectives of the institutions may differ fundamentally. For example,
banking emphasises depositor protection whereas in the case of securities market, it is investor
protection. The payment and settlement system has huge systemic risk associated with it and in the
case of insurance, the emphasis is upon asset protection. Such differences lead to basic differences in
the approach and management and, therefore, it would be useful to address implementation aspects
separately sector-wise as far as possible, even though the design may be centralised.
Fourthly, in implementing the Codes, since there is a multiplicity of institutions or arrangements for
regulating different financial sector segments like insurance, banking, securities markets and payment
and settlement, overall approach to cover different agencies in overlapping/grey areas of regulation
become important. In the absence of well-defined regulatory roles and responsibilities combined with
over-viewing or overseeing arrangements, there are possibilities for regulatory gaps/overlaps leading
to regulatory arbitrage by market agencies. The use of the word coordination is avoided deliberately,
preferring the word oversee since a rigid and centralised approach to compliance in this complex task
covering several institutions may be counter-productive.
Fifthly, transparency practices are often addressed to financial agencies (regulatory authorities) and
not applicable to companies or other entities in the private sector. The emphasis on the
implementation of standards and codes and accountability thereof is still heavily concentrated in the
official sector. There is some asymmetry here. An optimal balance between regulation and competitive
efficiency in the financial system and markets can be achieved only with equal emphasis on
responsibility and accountability of the private sector. The focus of IMF is also with regard to codes
mostly in respect of regulators and not so much with private sector. International accounting standards
and standards set by securities market associations are, no doubt, expected to cover issues relating to
private sector market participants. Every effort should be made to recognise and correct the
asymmetry.
Sixthly, financial agencies may be justified not to disclose some policy measures which are in
progress, contingency plans, corrective actions, emergency lending decisions and supervisory or
enforcement actions. Revealing of such information could be based upon case-by-case deliberations
and no standardisation is possible in such cases. It should also be emphasised that the transparency
practices may not be the same and the relevance and applicability of practices may differ between
financial sector agencies. For instance, 'market efficiency' should be relevant more for securities
regulatory authority; the 'market and systemic stability' would be more relevant for a central bank and
other supervisory agencies; and 'client-asset protection' would be more relevant for institutions like
Deposit Insurance Companies.
Seventhly, the practice evolved in India is in finding solutions through a participatory/consultative
approach even on major policy issues. Important guidelines are circulated/publicised in draft form for
consultation and discussion before implementing and making them operational. Technical advice is
sought from participants including academia on areas of market development and reforms. This is
perhaps a useful approach to enhance the quality of change and appropriateness of changes while
developing better acceptance among economic agents.
Eighthly, the implementation of codes must be treated as an ongoing process requiring awareness in
the market and the public and should not be treated as a one-time job.
Indian approach to implementation
I would like to take this opportunity to place before you the approach adopted in India in the
implementation of standards and codes.
Development of standards and codes is viewed as an integral part of the proc