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 The Role of Financial Self-Regulation in Developing Economies

By Biagio Bossone and Larry Promisel
Acknowledgments

1. Rationale for Financial Self-Regulation
    Financial policymakers today generally recognize that sound and stable long-term economic growth can best be supported by regulatory policies that minimize interference with the functioning of the market.1 Financial sector reforms in developing economies are thus increasingly oriented toward mechanisms to induce effective market discipline, and toward regulatory/supervisory regimes that are market-friendly or that mimic the market in driving agent decisions through incentives to honest and prudent behavior.
    Honest and prudent behavior by a financial market institution is integral to its
reputational capital, which in turn increases its franchise value. Private sector agreement on principles and rules for self-regulation can provide incentives for that honest and prudent behavior. Self-regulation, in turn, tends to emerge and to be effective when the franchise values of individual businesses in a community stand to receive a considerable boost from cooperation to reduce the costs to deal with limited trust and asymmetric information.
    Thus, agents have a strong interest in establishing long-term mutual ties to enforce honest and prudent behavior through self-policing arrangements, that is, to the capability of a system of private-sector agents to induce compliance with common rules of conduct from each agent, without resorting to exogenous rule-enforcing mechanisms. Self-policing can either be the result of agents having incentives to undertake behavior that conforms to the collective interest, or the outcome of agents having an incentive to mutually monitor behavior. (See Klein 1997, 1997a.)
    This paper discusses the basic features of financial self-regulation; the benefits and limitations of self-regulatory organizations (SROs); less ambitious alternatives; and the role of the public sector.

2. Basic Features of Financial Self-Regulation
    Spontaneous self-policing arrangements can be found in the history of international trade and commercial law, public security, maintenance of public services, and commercial bank clearinghouses. [Examples from history] In developing countries, such arrangements are used for governing and managing natural resources, also known as common pool resources. Self-policing arrangements allow participants to undertake transactions that would otherwise be unprofitable due to high transaction costs (Ostrom 1990). [Self-regulation for common pool resources]
    Self-policing arrangements may develop within financial communities as well (Goodhart 1988). In some cases, they evolve into full-fledged self-regulatory organizations (SROs), with internal statutory rules; dedicated financial resources; formal structures involving shareholders, managers, and employees; codes of conduct; and oversight procedures (Glaessner 1993). SROs could involve payments and securities settlement systems, interbank deposit markets, securities trading and stock exchanges, securities lending and clearinghouse services, deposit insurance, or credit information-sharing systems.
    SRO responsibilities could encompass: (a) regulation of market transactions, (b) regulation of market participants, (c) disputes resolution and enforcement actions, and (d) pre-commitment of resources. Each of these is discussed below.

Regulation of Market Transactions
    Self-regulation of market transactions ensures that they are executed and completed by each member according to pre-agreed rules and modalities. To this purpose, the SRO needs to exercise effective market and system surveillance and identify rules of information disclosure and sharing. Information is crucial for effective self-regulation: with limited information or with deliberately hidden information by members on their performance, there are few incentives for honest and prudent behavior.

Regulation of Market Participants
    Regulation of market participants ensures that members joining in the SRO have an adequate level of reputational capital and that they maintain it over time. This is accomplished through well specified

  1. Admission criteria requiring financial institutions wishing to join in the SRO to possess minimum conditions relating to capital, creditworthiness, risk-management capacity, technical and organizational requisites, and owners’ passing of a fit-and-proper test. Where the business franchise value from participating in the SRO is sufficiently high, admission criteria provide an incentive for institutions to build up their reputational capital. (In some arrangements—typically clubs—admission rules require new member candidates to be introduced and sponsored by senior members. The latter act as guarantors of the candidates’ reputation. As their reputation becomes vulnerable to the behavior of the sponsored candidate, if admitted in the arrangement, this mechanism puts pressure on sponsoring members to be confident enough about the true quality of the sponsored candidates.
  2. Rules of conduct governing member relationships and their business activity, including rules on ethical behavior, compliance with membership obligations, sound performance, and maintenance of minimum levels of financial strength. Compliance with such rules is what allows for transaction costs between members to be reduced, and represents one benchmark against which the reputational capital of each member is observed by the market.
  3. Sanctioning criteria for non-compliance. Punishing non-compliance is a necessary component of the incentive structure underlying self-regulation. In the event of serious misbehavior (including, among other things, insider trading), members must ultimately face the risk of suspension and, eventually, exclusion from the SRO. Members must also be motivated to report on misbehavior of their counterparties to transactions.

Dispute Resolution and Enforcement Actions
    The efficiency of
dispute resolution and adjudication processes is crucial for the success of the SROs. The government should not preclude (indeed, it should encourage) private mechanisms and institutions that serve to enforce good conduct, so long as they are consistent with national law. This would be particularly useful in countries with slow judicial processes and where the general orientation of the law is biased against private commercial practice. In a number of cases, out-of-court procedures have been successfully employed to govern corporate restructuring processes (Claessens 1998).

Pre-Commitment of Resources
    Incentives in financial self-regulation—especially for inter-bank payment and settlement systems—can be strengthened by members agreeing to individually pre-commit resources (in the form, for instance, of mutual lending obligations or collateral pooling) that would be mobilized in the event of one or more members running into illiquidity or insolvency problems. Pre-commitments generate incentives for each member to monitor the behavior of the others, to agree on and to enforce information disclosure rules, and to take action in case of misbehavior.
[Self-regulation in payment and settlement systems]

3. Limitations and Benefits of Self-Regulation
    Some problems may complicate financial self-regulation. For example:

  • SROs might transform themselves into cartels and jeopardize competition.
  • Short-term tensions between the managers and the authorities responsible for SROs—such as, for example, on the looseness of listing requirements—might either discourage participation or diminish long-term confidence in the market.
       Other complications likely arise in developing countries:
  • Scarcity of institutional and human resources may constrain the quality of oversight.
  • Lack of reasonably homogenous institutions could impede the formation of balanced structures within SROs.
  • With limited competition in securities markets, self-regulation may not be enough to ensure safe and efficient markets.

    Even so, financial self-regulation in developing economies could help improve the efficiency-stability tradeoff. Because of their knowledge and experience, and because of their commercial interest, SRO members are better placed than government bureaucrats to design rules consistent with the operational features of their business, to keep their operational processes and infrastructures apace with technological progress, and to improve their business standards. In particular,

  • Since information is vital to each SRO member, an SRO setting is better positioned than government regulatory agencies to achieve enforcement of disclosure rules through peer monitoring.
  • By being part of the industry, in economies with liberalized and open financial markets, SRO owners and managers have an incentive to keep up with the institutional and organizational developments in other economies.
  • The SRO model offers an appropriate institutional setting to develop market microstructures that facilitate securities trading and market liquidity.2

Finally, incentives to induce private-sector self-policing would mobilize resources that would complement the public sector’s scarce resources used to enforce rules and best practice standards.

4. Less Ambitious Alternatives
    Some private sector arrangements—such as trade associations—are less ambitious than full-fledged SROs. They do not yield all the benefits that an SRO might provide, but they may not entail all of the costs, either.
    Trade associations are formed to represent the mutual interests of their members. They typically are involved in monitoring developments in their corresponding market and play a role in the dissemination of information. They may go further, perhaps developing (a) codes of conduct (like the code of conduct for trading of emerging markets instruments developed by EMTA—the Emerging Markets Traders Association—
(http:\\www.emta.org), or (b) common documentation like the master agreements formulated by ISDA—the International Swaps and Derivatives Association (http:\\www.isda.com).
    Given the externalities, such activities are generally to be encouraged. They embody—to an extent not possible if done by the official sector—the special expertise of the members, and they address the problems or issues that members deem to be important. Moreover, such products are possible without the stringent admission criteria and enforcement provisions that can pose problems in more ambitious arrangements.

5. Role of the Public Sector
    Government has a key role to play in supporting the formation of financial community ties along self-regulatory principles. It could delegate to domestic financial institutions the task to form industry groups for governing and running specialized markets. SROs should organize themselves, address the planning and operational issues, identify functions, rules and codes of conduct, and set up oversight mechanisms, all under the supervision of the relevant public authorities. Participants to SROs could be called upon to share in the financing of the investment and operating expenses involved in its functioning.
    By adding strands to the web of restraints that curb imprudent and honest behavior, SROs can strengthen the financial system. They should be seen as complements of, rather than substitutes for, prudential regulation and supervision. (See the principles for self-regulation developed by IOSCO (International Organization of Securities Commissions —
(http:\\www.iosco.org). Authorities should

  • Ensure that SRO rules are fair and based on stability and efficiency principles.
  • Protect market competition and ensure that SRO information, monitoring and sanctioning systems are compatible with fair competition.
  • Assess SRO entry and sanctioning criteria, and ban discriminatory and unfair practices.
  • Ensure that SRO rules and operations are not detrimental to small participants and consumers, and that under-served constituents have fair access to their services.
  • Ensure that SRO members, shareholders, managers, and employees have proper incentives.
  • Make sure that members are fully aware of the risks of their business, and that their technical and operational capacity, including their risk-management capacity, is sufficient to make their system robust and resilient against large financial and operational shocks

Lastly, monitor the operation of SROs and intervene promptly if their action deviates from their purposes3.


References
Benson, Bruce L. 1989. “The Spontaneous Evolution of Commercial Law.” Southern Economic Journal, January, 644-61. Also reproduced in Klein (1997a) 165-90.
--------. 1994. “Are Public Goods Really Common Pools? Considerations of the Evolution of Policing and Highways in England.” Economic Inquiry April, 249-71.
BIS. 1997. “Financial Stability in Emerging Market Economies: A strategy for the formulation, adoption, and implementation of sound principles and practice to strengthen financial systems.” Working Party on Financial Stability in Emerging Market Economies. Basle: Bank for International Settlements.
Bossone, Biagio. 1998. “A Central Bank Perspective on Reducing FX Settlement Risk.” Payment Systems Worldwide Winter 1997-98.
--------. 1998b. Circuit Theory of Finance and the Role of Incentives in Financial Sector Reform. Policy Research Working Paper No. 2026, Dec. (Washington, DC: The World Bank).
--------. 1999. The Role of Trust in Financial Sector Development, forthcoming in Policy Research Working Paper series. Washington, DC: The World Bank.
--------. and Larry Promisel. 1998. Strengthening Financial Systems in Developing Countries. The Case for Incentives-Based Financial Sector Reforms. Washington, DC: The World Bank.
Claessens, Constantijn. 1998. Systemic Bank and Corporate Restructuring: Experiences and Lessons for East Asia, September .Washington, DC: The World Bank.
Fuller, Lon L. 1964. The Morality of Law. New Haven: Yale University Press.
Glaessner, Thomas. 1993. External Regulation Vs. Self-Regulation: What is the Right Mix? The Perspective of the Emerging Securities Markets of Latin America and the Caribbean, Regional Studies Program Report from the Latin America and the Caribbean Technical Department, June. Washington, DC: The World Bank.
Goodhart, Charles. 1988. The Evolution of Central Banks Cambridge, Mass.: MIT Press.
Greif, Avner. 1989. “Reputation and Coalitions in Medieval Trade: Evidence on the Maghribi Traders.” The Journal of Economic History, Vol. XLIX, No. 4, December. Also reproduced in Klein (1997) 137-64.
Group of Ten Central Banks. 1990. Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten, November. Basle: Bank for International Settlements.
--------. 1996. Settlement Risk on Foreign Exchange Transactions, Report by the Committee on Payment and Settlement Systems March. Basle: Bank for International Settlements.
--------. 1998. Reducing Foreign Exchange Settlement Risk: a Progress Report, Report by the Committee on Payment and Settlement Systems, July. Basle: Bank for International Settlements.
Klein, Daniel B, ed. 1997. Reputation. Studies in the Voluntary Elicitation of Good Conduct. Ann Arbor: The University of Michigan Press.
--------. 1997a. “Trust for Hire: Voluntary Remedies for Quality and Safety.” In Klein (1997a) 97-133.
La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny. 1996. Law and Finance, NBER Working Paper, No. 5661, July. Cambridge, Mass.: National Bureau of Economic Research.
--------. 1997. “Legal Determinants of External Finance.” Journal of Finance 52(3), July, 1131-50.
Levine, Ross, Norman Loayza, and Thorsten Beck. 1998. Financial Intermediation and Growth: Causality and Causes, June. Processed.
Ostrom, Elinor. 1990. Governing the Commons. The Evolution of Institutions for Collective Action. Cambridge, UK: Cambridge University Press.
Ryser, Marc. 1997. “ Sanctions Without Law: The Japanese Financial Clearinghouse Guillotine and its Impact on Default Rates.” In Klein (1997) 225-40.
Stiglitz, Joseph E. 1993. “Peer Monitoring and Credit Markets.” In K. Hoff, A. Braverman, and Joseph E. Stiglitz , eds., The Economics of Rural Organizations. Theory, Practice and Policy, 70-86. Oxford: Oxford University Press.

Incentives. On the role of incentives to elicit good conduct from market professionals, see Klein (1997). Recent works from the authors of this note (Bossone and Promisel 1998; Bossone 1998b, 1999) explore in depth the role of incentives in soliciting trustworthy behavior from financial agents, while also improving the economy’s overall efficiency/stability tradeoff. They argue that incentives and incentives-based institutions should be used to complement government regulatory and supervisory action, especially in developing economies where resource scarcities are relatively more serious.

Reputational capital. The reputational capital of a financial institution is the value of the institution’s commitment not to breach (implicit or explicit) contracts and take risks that might endanger its compliance with contractual obligations. If the institution breaks the promise underlying the contracts, its reputational capital may be damaged or destroyed. Reputational capital is a complex set of variables that signal at any point in time the institution’s ability and willingness to fulfill its obligations. The most relevant variables are as follows:

  • the institution’s long-term mission and strategy,
  • market presence and established name,
  • market knowledge and information,
  • financial strength and profitability,
  • organizational and governance structure,
  • risk management capacity,
  • record of compliance with legal and financial obligations,
  • quality of service and advice delivered,
  • quality of projects financed,
  • quality and ethics of management and personnel, and
  • transparency.

    For an institution to invest in reputational capital, honesty and prudence should be rewarded. An appropriate rewards structure links the institution’s franchise value to its past record of business conduct and practice: as the institution proves dishonest or imprudent, its counterparties and customers withdraw or refrain from dealing with it, causing it to lose all future profits. Thus, the higher the franchise value deriving from a reputation of being an honest and prudent institution, the stronger the incentive to act honestly and prudently and to forego short-term gains from dishonest and imprudent behavior, and correlatively higher is the social return from reputational capital.

Franchise value. The franchise value of an institution is the present value of the stream of its expected future profits. Other things being equal, franchise value is dependent on business continuity and, thus, on the opportunity for repeated and extended dealings that augment the potential for profits over time. In financial markets where prudent and honest behavior is appropriately rewarded, the prospect for a higher franchise value provides a strong incentive for private-sector institutions to invest in reputational capital. From consumer choice theory, a repeated dealing holds when the quality of the product or service received from a supplier on first bargain induces the customer to continue a commercial relationship with the same supplier, on the expectation that the latter will guarantee or improve the quality delivered in the attempt to preserve its reputational capital. Extended dealings hold when the result of a dealing are communicated from the customer to other consumers who would use the information to decide whether or not to deal with the supplier. Investing in reputational capital raises the likelihood of successful repeated and extended dealings. These, in turn, increase the supplier’s franchise value.

Examples from history. The examples drawn from history show that spontaneous cooperative arrangements have developed within the private sector in the absence of government action to overcome constraints to profitable international business resulting from limited information and incomplete trust: the prospects of long-term profits drove agents to establish self-policing rules that made those prospects possible by reducing the costs of transacting. More recently, with globalization eroding the effectiveness (and increasing the externalities) of domestic policy action, governments have recognized the importance of international cooperation, and thus actively promote international private-sector cooperative arrangements at the industry levels.
    In the area of international finance, a notable example is provided by the implementation of the strategy of the G10 Central Banks for the reduction of settlement risk in foreign exchange transactions (see Group of Ten Central Banks 1996 and 1998; Bossone 1998).
    The following are historical examples of self-regulatory arrangements in the areas of (a) international trade, (b) commercial law, and (c) law enforcement. The examples show how appropriate incentive structures have induced private-sector agents to form cooperative arrangements for the enforcement of individual prudent and honest behavior.

How 11th century Maghribi traders regulated themselves (Greif 1989)

        Almost a thousand years ago, Maghribi traders had probably one of the first private-sector, self-regulatory schemes based on market incentives for reputational capital and mutual trust. Of course, to them it was just good business sense.
        The Maghribi were Jewish traders who lived in the Abbasasid caliphate (centered in Baghdad) until the first half of the tenth century, when they emigrated to North Africa. They coped with the uncertainty and complexity of trade by operating through business associates, upon whom they relied to handle some of their business dealings abroad. In the jargon of today’s economists, agency relations at the time were characterized by asymmetric information—that is, merchants could never be sure that agents actually handed over the entire proceeds of business done abroad on their behalf. And courts were generally unable to verify agents’ claims and actions or track down an agent who absconded with the merchant’s money.
        The Maghribi traders solved the problem by organizing themselves into a coalition that served as a grapevine for information on (honest and dishonest) agents. Coalition members were governed by an implicit contract which stated that members would employ only member agents. Any agent who treated a member unfairly could never hope to do business again with other members. The flow of information that uncovered cheating also added to the standing (reputational capital) of honest coalition members. As a result, agents resisted double-dealing, since the loss in business (franchise value) far outweighed the gain from cheating a Maghribi trader.

An early example of self-regulation: the Medieval mercantile law in Europe (Benson 1989 and 1994)

        In Europe, in the eleventh and twelfth centuries, as more and more rural folk moved to towns and cities, a new class of merchants emerged to meet the demands of the growing urban population. Significant barriers had to be overcome, however, before substantial interregional and international trade could develop: different languages and cultures, as well as geographic distances, frequently prevented direct communication, let alone the building of strong personal bonds that might lead to mutual trust. Also, local and often contradictory laws and business practices produced hostility towards foreign commercial customs, usually leading to confrontations.
        It was during this period that the basic concepts and institutions of modern Western mercantile law (lex mercatoria) were formed. After the eleventh century virtually every aspect of commerce in Europe (and even outside Europe) was governed by this body of law. In fact, the commercial revolution of the eleventh through the fifteenth century, and the later industrial revolution, could not have happened without it.
        Mercantile law was voluntarily adjudicated and voluntarily enforced. Merchants formed their own courts to adjudicate disputes. These courts were also a sort of clearinghouse for reliable information on the reputation of individual merchants. Courts’ decisions were accepted by winners and losers alike because they were backed by the threat of ostracism from the merchant community. A merchant who broke an agreement or refused to accept a court ruling would not be a merchant for long. The threat of a boycott of all future trade (and, therefore, loss of livelihood) proved effective enough.

Policing in Anglo-Saxon England (Benson 1989 and 1994)

        In the early Anglo-Saxon Law, before English kings began to concentrate and centralize power, offenses such as homicide, assaults, rape, and thefts were treated not as crimes against the state, but as torts against persons or property. If an accused offender was determined to be guilty of violating some victim’s rights, he was liable for restitution to his victim in the form of a fine or indemnity to be paid to the victim. Even a deed of homicide could be paid for by money, and the offender could thus buy back the peace he had broken. (The terms of restitution could be extended to take account of the offender’s repayment capacity. He could also pay off his debt through indentured servitude.)
        In tenth-century England, voluntary groups—called the “hundreds”—provided the police system of the country. The two primary purposes of these organizations were to facilitate cooperation in rounding up stray cattle and in pursuing justice. When a theft occurred, for example, the several “tithings”—that is, groups of neighbors—that made up the hundred were informed. They were bound by a reciprocal duty to cooperate in pursuit and prosecution. Cooperation improved the quality of pursuit and prosecution: cooperation of non-victim witnesses could be essential for prosecution; pursuit by the victim alone was less likely to succeed than pursuit by a large group; moreover, ostracism by a whole community group could make punishment very costly indeed. A strong incentive for cooperation within the tithings and hundreds was that these organizations proved very effective to ensure restitution to the victims.
        The members of the tithings had opportunities to interact frequently and repeatedly on several dimension of social life, so that reputation effects had an important role in sustaining cooperation. Refusal to pay restitution to a member of the community in good standing would put the offender outside the protection of the law, and physical retribution of the offender became the responsibility of the entire hundred. On the victim’s side, refusing restitution and seeking personal revenge would cause the original victim to become an outlaw. The community threat of outlawry and physical retribution generally induced the reluctant offender to pay the victim and this to accept restitution. Also, someone who did not cooperate in a tithing would not have access to the policing services of the group in the event of an offense received. This would make him an easier target for potential offenders. Furthermore, the non-cooperative individual would be ostracized by other forms of social interactions, so that in fact the costs of non-cooperation were considerably high.

Self-regulation for common pool resources. In his empirical investigation, Ostrom (1990) observes that all successful cases of self-regulatory arrangements for common pool resources featured a number of operational principles: (1) clearly defined boundaries and membership; (2) congruence between members’ resource appropriation and provisions; (3) member participation in defining operational rules; (4) monitoring; (5) graduated sanctions; (6) conflict-resolution mechanisms; (7) members’ right to devise their own institutions unchallenged by government; (8) in the case of larger systems, activities were organized in multiple layers of nested enterprises. Certain conditions are necessary for self-policing arrangements to emerge:
    First, the relationship must result from a deliberate and voluntary agreement of the parties involved: they are those who create the arrangement.
    Second, fair exchanges of values must be anticipated.
    Third, each member may be called on by others to provide, and may equally call on others to provide, the services agreed under the arrangement.
    Fourth, each member must be in a position to own the (positive or negative) rewards from his action. Members must be held responsible and accountable for their action, and must therefore be able to appropriate the benefits and costs associated with their action.
    If these conditions are met, the agents perceive potential gains from tying mutual bonds with each other by entering into (formal or informal) arrangements, and potential costs from contravening such arrangements once entered into. See also Fuller (1964) and Benson (1989 and 1994).

Reporting on misbehavior. In a study on informal finance, Stiglitz (1993) shows that peer monitoring improves the debt-repayment capacity of borrowers and reduces the transaction costs associated with lending to informal borrowers. In a self-regulatory environment, cooperation among members on information disclosure and sharing is essential to activate the relevant incentives to proper individual behavior. In fact, specific incentives can be used to enforce that cooperation. See the following example.

The Tokyo Clearinghouse (Adapted from Ryser 1997)
    The Tokyo clearinghouse for bill and check transactions is an example of a self-regulatory organization (SRO) with a strong information-enforcement mechanism, for which it has derived its nickname of clearinghouse “guillotine.” The clearinghouse is privately operated and does not rely on government law. It requires that banks participating in the clearinghouse arrangement must suspend their dealings with the issuers of defaulted notes or checks presented through the clearinghouse. The arrangement goes back to 1894, when the banks of the Tokyo Bankers Association drew up the binding rules concerning the suspension of transactions. Before the new arrangement, a loose understanding had existed among the banks to inform one another of the names of the issuers of defaulted notes, and to deal carefully with wrongdoers. The new arrangement developed slowly from such an informal understanding to a regime in which the suspension rule could be strictly enforced. Today, the main features of the system are as follows:

  1. If a person (individual or corporation) dishonors bills or checks twice during a six-month period, the financial institutions participating in the clearinghouse are required to halt all current account and lending transactions with the person for two years. (a) If the first bill is dishonored, the transaction bank of the issuer submits a notice of nonpayment to the clearinghouse; so does the collecting bank that brought the bill in for collection though the clearinghouse and to which the dishonored bill is being returned. (b) When the notice of nonpayment is presented, the clearinghouse issues a nonpayment report to every participating bank identifying the defaulter. (c) If the defaulter again dishonors bills presented through the exchanges within six months, a second nonpayment notice is issued, the party in question is suspended from banking transactions, and a suspension report is issued to all participating banks.
  2. When the suspended party is regarded to have recovered its reliability, its correspondent (participating) bank may request the clearinghouse to release the party from the suspension. A special committee considers the request.
  3. Any participating bank is subject to penalties (which may range from insignificant fines to exclusion from the clearinghouse) for the following offenses: (a) Dealing with a suspended party. (b) Committing a procedural error regarding nonpayment report, cancellation, or suspension. (c) Failing to submit its notice of nonpayment.

The success of the clearinghouse in maintaining a high standard of payments clearing relies on the strength of its incentive structure, whereby membership is used as a disciplinary tool to elicit desired bank behavior. In particular, one of the most effective disciplining features is the sanctions against banks that fail to perform their reporting duties and uphold any suspensions. This prevents banks from dumping “lemons” on their competitors.

Dispute resolution. As the examples from history show, self-policing groups have successfully governed themselves even in the absence of coercive power of government. Members formed their own courts to adjudicate disputes, and courts’ decisions were accepted by members under the threat of reputational capital losses. Private adjudication schemes guaranteed speed, informality, and technical competence. The adjudicative procedures and the rules adopted by the courts were designed to facilitate commercial interactions. The importance of legal certainty for growth is assessed in recent studies by La Porta and others (1996, 1997) and by Levine and others (1998).

Self-regulation in payment and settlement systems. An example of how private-sector cooperation can achieve a great deal of self-regulation in the area of payment systems is the Euro Clearing and Settlement System. A short description of the self-regulatory aspect of the system is reported below.
    The Euro Clearing and Settlement System shows how a cooperative, private sector (commercially-based) arrangement can solve the information and trust problems in a cross-border payment system. Owned and operated by an association of commercial banks, the Ecu Banking Association (now Euro Banking Association), was established in 1985 as the Ecu Clearing and Settlement System and headquartered in Paris for the clearing and settlement of payments denominated in a currency (then the ecu) for which no central bank of issue and lender of last resort existed. Settlement took place at the Bank for International Settlements (at the European System of Central Banks from January 1, 1999).
    Banks can be admitted as clearers by a Euro Banking Association committee, subject to compliance with requirements based on credit standing, technical and operational capacity, and willingness to participate (within approved limits) in risk-sharing schemes that ensure daily completion of settlement. Similarly, banks can be excluded in cases of serious deterioration in credit standing, or persistent non-compliance with the system’s rules. The institutional and organizational structure of the Association ensures participation of all members in decisionmaking. Risks connected to the highly interrelated nature of the payment and clearing business, as well as the lack of a lender of last resort, have so far provided the members with strong incentives for their own prudent behavior, careful monitoring of counterparty behavior, and improvement of the system’s robustness.
    In the absence of a central bank of issue, the system operates as a closed circuit where each participant with a provisional net debit position can only square it by borrowing excess funds from participants with a provisional net credit balance. Successful daily clearing relies on the willingness of banks to re-flow their surpluses into the system to finance banks in deficit. The system also provides for facilities that commit banks with surpluses to channel liquidity (up to a limit) to a deficit (solvent) bank if one participant opposes lending to that bank. Clearing banks have access to real-time information that enables them to monitor the clearing. The system establishes multilateral and bilateral mandatory limits on each bank’s net debit and credit position, and breaches are subject to sanctions. Compliance is enforced through automated procedures.
    In the past, the system has been under the oversight of the European Union’s central banks, then the European Monetary Institute, in cooperation with the central banks. The role rests now with the European System of Central Banks. Attention has been focussed on ensuring the smooth functioning of the system and monitoring its impact on ecu money markets. The overseers have also played an essential role in inducing the Euro Banking Association to take structural measures to strengthen the stability and operational security of the system according to internationally agreed minimum standards (see Group of Ten Central Banks 1990). Under the overseers’ pressure, the Association is currently developing a collateral-based liquidity-sharing arrangement and a loss-sharing arrangement to strengthen the system against insolvency of any major participant. Both schemes will reinforce the incentives for mutual monitoring and prudent risk taking.
    Experience shows that, with the responsibility for the system’s operation, maintenance, improvement, and design of rules resting with the participating banks, and through the continuous dialogue between the oversight authorities and the Euro Banking Association, satisfactory progress toward robustness can be achieved in ways that take into account both the need for economic and operational efficiency and the interest of systemic stability.


1As the Report of the Working Party on Financial Stability in Emerging Market Economies (Bank for International Settlements 1997) indicates, “A fundamental guiding principle in the design of all regulatory/supervisory arrangements is that they should seek to support and enhance market functioning, rather than displace markets”. The report emphasizes that “[w]here governments do intervene, it is important that they do so in ways that restore as fully as possible the channels of market discipline, to the extent that those channels are not disruptive to financial stability”. Elsewhere, the report recommends that “[w]here financial systems are less developed, a key objective of policy is to reduce the need for regulation in the future by improving the quality of private market forces”. Drawing on the historical experience of industrial countries, the Report goes on noting that “the emphasis in regulatory and supervisory approaches shifts as markets liberalise from explicit limits or other rules towards primary reliance on guidelines, supervisory assessments, and incentives for sound business behaviour on the part of owners, stakeholders and management”.
2For the role of SROs in the US securities and exchange markets, see
(http://www.nasdr.com) and, in particular, the speech delivered by M. L. Shapiro, President of NASD Regulation, Inc., at the Owen Distinguished Lecture Series, Vanderbilt University, Nashville, Tennessee, Apr. 3, 1996 (http://www.nasdr.com/1420/schapiro_01.htm).
3See, in this respect, the approach adopted by the Group of Ten Central Banks (1990) for the oversight of multilateral netting payment and settlement systems
(http://www.bis.org.publ/index.htm).

 

 ***

Biagio Bossone, Financial Policy Advisor, Financial Sector Strategy and Policy Group, The World Bank.
e-mail:
bbossone@worldbank.org

Larry Promisel, Senior Advisor, Financial Sector Strategy and Policy Group, The World Bank.
e-mail:
lpromisel@worldbank.org

Or contact Elena Mekhova, Team Assistant, Financial Sector Strategy and Policy Group, The World Bank.
telephone: 202/458-5984
fax: 202/522-2031
e-mail:
emekhova@worldbank.org

Acknowledgements:
We wish to thank P. Honohan for the helpful comments, and M. Lubrano for his suggestions and the background material provided to us.

 


Copyright 2000, Financial Sector of the World Bank Group, All Rights Reserved.

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