Weak credit evaluation and speculative lending, as well as a failure to control currency risk, contributed both to the outbreak of East Asia's financial crisis and to its amplitude. There is now general agreement that tighter regulation and supervision of domestic financial institutions are an essential element of financial sector restructuring. The motivation for greater regulation at the international or source country level is the belief that not all of the responsibility for, and costs of, such regulation should be borne by the recipient country, and even when regulation by recipients are in place, controls at source are capable of further reducing the probability of potentially destabilizing capital flows and financial crises.

Two aspects of regulation at the international level or source country level, namely tighter control of short term lending and portfolio investment flows, warrant further comment.

Short term external debt

As regards the extension of short term loans by international banks, they are already regulated by industrial country central banks and include provisioning against potential future losses on lending to emerging markets and capital adequacy requirements. However, existing regulations were not enough to discourage the excessive short term credit flows that played such an important part in the East Asian crisis. This has been partly attributed to a regulatory bias in the 1998 Basle Capital Accord whereby, for non-OECD countries, loans of residual maturity of up to one year have a risk weight of 20%, while loans over one year have a weighting of 100% for capital adequacy purposes. This has meant that to banks' preference for lending short term, especially in situations of perceived risk, added a regulatory bias that also encourages short term lending. Thus one way to exercise tighter controls on such lending would be to raise the cost to banks by increasing the risk weight of short term lending in setting capital requirements.

Portfolio flows

As regards portfolio investments, there is at present no international framework to regulate the flow originating from institutional investors such as mutual funds. This has been identified as an important regulatory gap given the increased importance of and volatility of such flows. One such proposal to increase the stability of mutual funds' investment in emerging markets is to require them to hold cash reserves amounting to some proportion of such securities. These reserves could then be tapped into in the event of large declines in shares values, thus reducing the incentive to dump such securities for the purpose of obtaining the liquidity needed to meet redemptions. A variant of this would be to hold risk weighted cash reserves in accordance with the creditworthiness of the countries in which mutual funds made their investments.