A World Bank report notes that to make the most of the $1.6 trillion in foreign reserves and $9.6 trillion in domestic financial sector assets, East Asia needs to further diversify its financial markets by developing its securities markets to improve intermediation, and provide a market price for risk.

June 22, 2006 – A new World Bank report released today suggests that East Asian financial systems can improve the efficiency of their use of fast accumulating foreign exchange and domestic financial sector assets. While banking systems have revived sufficiently since the 1997 crisis to be sound enough to provide credible deposit-taking services and to diversify their customer base, there is a need to further develop securities markets in both equities and bonds.

The report, entitled cites the accumulation of US$ 1.6 trillion in foreign exchange reserves and US$9.6 trillion in financial sector assets —at the end of last year – as the most significant development in the region since the 1997 financial crisis.

“These assets reflect not only the resumption of large capital inflows but also the region's own savings – which amount to almost a quarter of that of the US financial markets, and half that of Japan. This is a tremendous achievement,” said Kenneth Lay, the World Bank’s Acting Vice President and Treasurer, speaking at a joint World Bank-Hong Kong Monetary Authority conference. “These assets provide a good cushion against volatility in the international financial environment and provide an important opportunity for the region to meet its financing needs in the years ahead.”

The report argues that the success in resource mobilization needs to be supported by financial market diversification with the appropriate development of mechanisms for the sharing, transfer, and pricing of risks.

A vibrant East Asian financial sector, according to the report, should have at least three characteristics:

It should be highly diversified in its ability to cater to the needs of increasingly complex and sophisticated economies;
It should provide financial services efficiently; and
It should be robust to withstand a variety of shocks in a fast changing globalizing world economy

Policy-makers need to be aware of the transfer of risks from stronger private banks to public banks and from banks to the more weakly regulated non-financial bank institutions through derivative instruments.

The report notes that although securities markets have grown by 300 percent in the last 9 years, the banking sector, with US$5.5 trillion in assets, still dominates East Asia’s financial sector. The region’s institutional investor base of US$1.5 trillion is large, but has considerable potential for future growth given the large pool of savings which are currently deposited in commercial banks. To further develop the securities markets, the report highlights the need to foster greater liquidity and efficiency.

“While progress has been made in strengthening the banking sector in the region, policy makers need to focus on further developing the securities market and the bond market in particular. Much of the growth in the bond markets have been on account of bonds issued by governments, largely to restructure the banking system,” said Homi Kharas, the World Bank’s Chief Economist for East Asia and Pacific. “The key issue is the lack of liquidity in the secondary market which affects the efficiency of these markets, and limits the overall size of corporate bond markets.” The report notes that the efficiency and liquidity of these markets is affected by the availability of information to price securities accurately, by high transactions costs, and by the limited size and heterogeneity of the investor base. To enhance efficiency, the report notes, policy makers will need to address each of these elements.

The report also observes that the emergence of various initiatives for regional financial cooperation is providing an impetus to deepening and diversifying financial markets, by identifying impediments to cross-border investments, by providing greater liquidity, and by facilitating issuance by private sector participants. But the experiences with implementing the Asian Bond Funds Initiative shows that measures need to be taken in tandem at the domestic level. At the same time, regional financial integration can significantly enlarge the gains from domestic policy measures and make the development of domestic financial markets more viable.

“In essence, the report acknowledges the significant progress made by East Asia’s financial markets,” said Swati Ghosh, lead author of the report. “But going forward towards the goal of achieving really robust financial markets, there is still a lot of ground to be covered.” The report notes at least three key issues:

Strengthening implementation of corporate governance and information disclosure—the institutional underpinnings—is of paramount importance to enable investors to price securities accurately. Countries in the region have made considerable progress in strengthening the legal and regulatory framework with respect to corporate governance and disclosure requirements, and in strengthening accounting and auditing standards but greater focus on implementation and enforcement are needed.

The development of complementary or supporting infrastructure—such as repo markets, margin trading and derivatives—if developed within an appropriate framework, can be important means of reducing transactions costs. It also allows market participants to manage and transfer risks to those better able and willing to bear them and hence helps advance the development of robust financial systems overall. At the same time, the report notes the potential danger of inappropriate risk transfers through the use of such instruments, to institutions with weaker risk management capacity and to more weakly regulated segments of the financial markets—in particular from private banks to public banks and from banks to non-bank financial institutions. This calls for proactive measures by regulators and supervisors to monitor and contain these risks.

The need to broaden and diversify the investor base. The participation of investors with different preferences and appetites contributes to greater trading and liquidity, and more efficient markets. This will require further developing the domestic institutional investor base—pension funds, insurance and mutual funds—as well as fostering greater regional financial integration.