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Regulatory framework: Macro-economic effect on financial market

Md. Toufique Hossain
THE recent capital market debacle, which is not over yet, has shown that finance matters a lot and exerts a powerful influence on the world economy. The increasing importance of finance, both private and public, is being particularly felt in Bangladesh. Finance plays an essential role in the allocation of capital among sectors and countries. It is also a major factor of instability, both for the financial and the real sectors of the economy, at all levels — national, regional and international.
Forecasting of the evolution of finance is needed for regulation purposes: there is a need to adapt the rules to the transformation of capital markets in the future. The wide array of possibilities in the future ranges from: (a) reform based on micro prudential regulation to a strong state controlled macro prudential regulation; (b) regulation at national level to regulation at a global level; (c) strong capital control between economic areas to strong financial integration.
The view of financial operators is determinant in the making of future finance, since they will take strategic decisions in banks and financial institutions. According to bank managers and financial executives in Bangladesh, the main challenges are (a) improvement of risk management, (b) adaptation to changing regulations, (c) intensification of price competition, (d) concentration of financial markets, and (e) standardisation of financial operations to replace workers with machines. Thus, financial institutions will try to increase their size and reduce costs of financial transactions to deal with stronger competition in more globalised financial markets.
It is rather difficult to identify promising markets for the next 20 years. There are some emerging new markets such as ethical and green finance which could be destined to play an important role in the future, but it is too early to assess their future importance. This depends crucially on future innovations, which are closely linked to regulation.
The major players of financial markets will be both public and private entities. On the one hand, the growth in the number of sovereign wealth funds which prefer riskier investments could increase the exposure of the government controlled investments. If Bangladesh banks' purchases of safe assets reduce the interest rate, the growth of risky investments made by sovereign funds may lead to an increase in asset prices. On the other hand, private actors such as hedge funds
and private equity are called upon to play an increasing role.
The micro-prudential objective can be seen as limiting the likelihood of failure of individual institutions. Again, loosely put, this means limiting idiosyncratic risk. Micro-prudential regulation is concerned with the stability of individual entities and the protection of clients of the institutions. Macro-prudential objective can be defined as limiting the costs to the economy from financial distress, including those that arise from any hazard induced by the policies pursued. One could think of this objective as limiting the likelihood of the failure, and corresponding costs, of significant portions of the financial system. This is often loosely referred to as limiting "systemic risk."
Macro-prudential regulation is concerned with the stability of the financial system as a whole. Micro-prudential regulation consists of such measures as (i) the certification of those working in the financial sector; (ii) rules on what assets can be held by whom; (iii) how instruments are listed, traded, sold and reported; and (iv) measures of the value and riskiness of assets. Microprudential regulation examines the responses of an individual bank to exogenous risks. By construction, it does not incorporate endogenous risk. It also ignores the systemic importance of individual institutions such as size, degree of leverage and interconnectedness with the rest of the system. This is why there is a need to complement microprudential regulation with macro-prudential regulation. Macro-prudential approach to regulation considers the systemic implications of the collective behaviour of banks.
Micro-prudential regulation should be carried out by capital market and financial institutions supervisors, whereas macro-prudential regulation should be put under the responsibility of banks. The banks will need to monitor credit expansion which is a major channel of bubbles and financial crises. Such instruments as loan to value ratios and progressive compulsory reserves on bank credit may be used by banks to reduce credit cycles.
In brief, the recent debacles in financial markets have provided many examples of why the structure of the micro prudential and macro prudential are important. The choice of regulatory structure is a crucial part of setting micro prudential policy. On the other hand, macro prudential supervision is important for identifying necessary risk in financial systems.
The writer is a Stock market Analyst & Young Professional trainee in BRAC. E-mail: toufique2010@gmail.com