Financial liberalization and prudential regulation in East Asia: still perverse

Most authors now accept that in the context of financial liberalization and deregulation, weak prudential regulation and institutions created substantial vulnerabilities in various Asian countries in the lead-up to the 1997-8 financial crises. The proposed solution, touted by the leading developed countries and the major international financial institutions and accepted by most governments in Asia, is to upgrade the domestic economic governance framework in key emerging market countries. A core element of recent IMF packages has been to facilitate a move from a ‘relational-patrimonial’ system of financial regulation towards a western-style ‘rules-based’ system of prudential regulation and supervision. At the same time, the process of financial liberalization begun in the 1980s in the crisis countries has been entrenched and accelerated by the IMF programmes of the late 1990s. I argue that in spite of all the efforts at regulatory upgrading, prudential regulation continues seriously to lag the process of financial liberalization. That is, sequencing remains perverse in most East Asian countries, essentially for political economy reasons. Implementation failures are rife in a number of crisis-hit countries. The international financial community has considerably underestimated the difficulty of upgrading domestic regulatory frameworks and institutions in the crisis countries. Formal convergence towards western regulatory standards has occurred, but divergence continues in practice given strong pressures for regulatory forbearance in countries with unresolved financial and corporate sector problems.