According to estimates by the Institute of International Finance, net private capital flows into emerging markets in Asia increased nearly six times from 1998 to $ bn in 1999, and are forecast to increase again by 50% to $ bn in 2000. There is therefore a real danger that we might forget the severe pains inflicted by the Asian financial crisis over the past two years. It is also easy to forget the lessons learnt and to become complacent. However, if the recovery in the region is to be sustainable, we should remain vigilant and beware of the risks lurking under these bubbling activities. Risks and challenges in coping with international capital flows Challenges of domestic structural reforms In order to address such risks, we would need to tackle three challenges faced by Asia. The first challenge is that the globalisation and liberalisation of markets require structurally sound and resilient domestic systems. Prior to the crisis, the banking systems were often inadequately supervised and were prone to incurring excessive maturity mismatch risks by borrowing short-term funds to finance long-term investments. Moreover, the corporate sectors of many Asian economies were over-stretching themselves by engaging in risky or unproductive investments. To make things worse, both the banks and the corporates were taking excessive currency risks by borrowing in foreign currencies to fund projects that could only generate income in domestic currencies. Poor risk management on the part of banks, ineffective banking supervision, political interference, and a critical lack of transparency prevented disciplinary mechanisms from functioning properly.

This is eminently logical and sensible, since with more cautious bank lending and enhanced risk management within the HLI sector, it should be very hard for the HLIs to build up excessive leverage and concentration in the major financial markets. This measure is being pursued with earnest in both the public and private sector. The Basel Committee on Banking Supervision, and IOSCO have issued respective guidelines on sound practices for interactions with HLIs for banks and securities firms. The latest discussion has focused on the kind of supervisory incentives for the compliance of risk management standards. The Basel Committee on Banking Supervision has put forward two proposals for the revision of the Capital Accord, which would help address the concerns on HLIs. One is abolishing the maximum 50% risk weighting for non-bank OTC derivatives exposures; and the other is encouraging counterparties to impose an initial margin on repo transactions. From the private sector, the Counterparty Risk Management Policy Group formed by twelve leading international financial institutions produced a report in June 1999. Five major hedge funds also produced an industry group report in February 2000 on improving counterparty risk management and internal control. While we agree that enhanced risk management of HLIs and their counterparties is a useful first line of defence, two major concerns remain. First, the return of competitive pressure may lead to a relaxation or even a breakdown in risk management standards again in the future.