Banking Supervision and Regulation: International Trends

Remarks by Andrew Crockett, General Manager of the Bank for International Settlements and Chairman of the Financial Stability Forum, at the 64th Banking Convention of the Mexican Bankers' Association, Acapulco, March 30, 2001.

Es un gran placer para mí estar aquí en Acapulco para participar en esta Convención Bancaria de la Asociación de Banqueros de México. Desde hace ya mucho tiempo el Banco de Pagos Internacionales mantiene relaciones estrechas con el Banco de Mexico. Estas relaciones se hicieron aún más fuertes en el año mil novecientos noventa y seis, cuando el Banco de México se convirtió en miembro del BPI, al mismo tiempo que otros ocho bancos centrales de grandes países emergentes. Recientemente, en noviembre del pasado año, el BPI mantuvo en la Ciudad de México su primer Consejo de administración en el hemisferio occidental. Esta tendencia a un fortalecimiento de la cooperación es seguro que continuará en el futuro. Tengo el privilegio de anunciar hoy que el BPI proyecta abrir en México una oficina de representación para el hemisferio occidental en cuanto sean completadas las formalidades administrativas necesarias ante el Gobierno mexicano.

The subject of this session of the convention is international trends in bank regulation. It is an appropriate subject to discuss, since all of the forces that are operating at the international level are affecting national economies too. Mexico, with its growing integration into the world economy and global capital markets, is as exposed as any to these trends.

The Mexican banking system has had more than its share of turbulence in the past two or three decades. Banks have moved back and forth from public to private ownership, and the wrenching crisis of 1994-95 left a particularly strong mark on banks and the financial system. Through all this history, the basic objective has been the same: to try and put the financial sector at the service of the real economy, by fostering an efficient and resilient system of financial intermediaries. We are coming to realise that the way to achieve this goal is to set the energy and innovative capacity of the private sector within a framework of prudential oversight that ensures its stable operation.

Perhaps the most striking trend in financial sector supervision over the past two or three decades has been the realisation that regulation should respond to the realities of the market, rather than the other way round. With that simple, but profound insight in mind, I will begin my remarks by looking at the forces that have been shaping the evolution of financial markets, and that will continue to do so in the years ahead. Against that background, I will then try to assess how financial supervisors around the globe have been responding to this evolution. My perspective will be that of the financial sector as a whole, since one of the key trends as we enter the 21st century is the integration of previously distinct patterns of financial intermediation.

Innovation and Deregulation: Consequences for the Financial Sector

The most basic forces affecting the shape of the financial sector are the same as those affecting the rest of the economy. They are the quickening pace of technological innovation, especially in data processing and communication; and the growing acceptance of market processes as a basic determinant of resource allocation.

These forces have had particularly profound effects on the financial sector, for at least two reasons. First, the financial sector is information intensive, and the greatest innovations of recent years have been in the processing and transmission of information. Second, the financial sector was among the most heavily regulated, with most countries having, until as recently as 20 years ago, extensive controls on prices, entry to the industry, competitive practices, and portfolio composition.

The impact of deregulation and innovation on banking and the rest of the financial sector has been profound. I will identify five trends that will be central to what I will have to say later, on supervision and regulation. These are: globalisation and market integration; the increasing complexity of financial instruments; securitisation; intensified competition; and consolidation. These are trends with many common strands and channels of interaction.

For the financial sector, Globalisation means that the barriers between different financial markets are coming down. Capital can flow more easily to locations where it receives the best reward; institutions have easier access to foreign markets; and boundaries between different kinds of financial activity are becoming blurred. To some extent this is happening because financial engineering has rendered previous administrative controls obsolete; and to some extent it represents a willing acceptance of a more free market philosophy. But whatever the cause, it means that finance is increasingly global and integrated. Prudential supervision has to adapt to that reality.

Securitisation is both supply and demand driven. On the supply side, institutions originating credits, typically banks and other mortgage lenders, have sought to dispose of parts of their portfolios in order to free up capital resources for other lending. On the demand side, institutions such as insurance companies and pension funds have found themselves with continuous inflows of funds needing placements in marketable assets.

The increasing complexity of financial instruments is also both supply and demand driven. Technological advances in the processing of information (consider, for example, of the development of option pricing theory) have permitted the independent pricing of risk factors that were previously bundled together in the same instrument. At the same time, the intensification of financial intermediation has given rise to an explosion in the demand for hedging (and position-taking) instruments. The good news is that the new financial instruments have enormously improved the technology of risk-management, thereby improving the climate for real and financial investment. The downside is that these same instruments, if not properly understood and used, increase the potential for loss, whether resulting from inadequate understanding or deliberate leveraged bets.

Enhanced Competition has been a prime objective of much of the deregulation and privatisation that has taken place in the financial industry. But the competitive climate has been sharpened by other developments, too. The focus on shareholder value has induced banks' managements to pay more attention to the risk-adjusted rate of return on equity. Once again, there is good news and bad news in this story. The good news is that the financial industry is induced to use its capital more efficiently and financial services have become cheaper to end-users. The bad news is that the cushion against bad luck or bad judgement is thinner. Franchise values are much smaller, so that an erosion of capital more quickly leads to the threat of failure (and the temptation to take unwarranted risks to stay in business).

The final trend to which I would like to draw attention is that of consolidation. Consolidation in the financial industry has so far been mainly within national markets, and within particular market sectors. Looking ahead, however, it seems likely to be reflected increasingly in cross-border mergers and alliances, as well as in the formation of groups spanning different financial activities - commercial banking, fund management, insurance and investment banking. Yet whether the trend toward consolidation will be uniform is far from clear. It seems likely that there will continue to be room for specialist service providers. And there may be consumer resistance to the quasi-imperial spread of monolithic financial services firms. Also, the impact of the internet on business models in the financial sector has still to be absorbed.

Regulatory and Supervisory Implications

The trends in the financial sector that I have just been talking about have a number of implications for the focus of supervision and for the way in which supervisory responsibilities are allocated. I will consider six issues. These are: the location of institutional responsibility for supervision; how to improve the risk-sensitivity of prudential regulations; the increased reliance on supervisory review and market discipline; the need to strengthen financial infrastructure; attaining cross-country consistency ("level playing field"); and marrying the micro- and macro-prudential aspects of supervision.

1. The allocation of supervisory responsibilities

The question of where authority for the supervision of banks and other financial institutions should reside is now the subject of intense debate. Practice varies widely. In many countries, responsibility for banking supervision rests with the central bank; while supervision over other financial institutions is typically vested with other agencies. But there are several examples of countries moving away from this model. Some, such as the United Kingdom, Japan and Korea have adopted the model of a single financial regulator, outside the central bank and independent also from direct political influence. This is the model which Germany also proposes to follow.

There seem to be two main reasons for the adoption of this kind of model. The first is that, since the boundaries between different kinds of financial institution are becoming more blurred, it makes sense to integrate the supervision of all financial institutions in a single agency. To set up an authority independent from the central bank has, in this view, the advantage that it avoids the presumption that lender-of-last-resort privileges are being extended, and allows the central bank to concentrate single-mindedly on its main objective, price stability. Moreover, it avoids a concentration of power in the hands of the central bank that some might see as excessive.

But there are arguments on the other side. In many countries, banks remain relatively distinct from other financial institutions. Most emerging market countries, for example, are still predominantly dependent on banks for financial intermediation. Moreover, it is generally recognised that it is desirable for the monetary and prudential authority to work closely together, particularly in times of financial market stress. This is easier if the functions are combined in a single institution. Finally, it is argued that in countries where the necessary resources are in short supply, the skills, experience and status of the central bank can be a valuable asset in assuring independent and rigorous supervision.

Seen in these terms, I do not believe there is any "right" answer to the question of where supervisory responsibility should be located. Different countries are therefore likely to come up with different models. What is clear, however, is that whatever the institutional design, mechanisms must be in place for the timely sharing of information between regulators of different institutions, and between the prudential supervisory and the monetary authorities.

2. The quest for greater risk-sensitivity

I turn now to the issue of improving the risk sensitivity of regulatory arrangements. This is the essence of what supervisors have been striving for, both at the national and at the international level, since at least the establishment of the Basel Committee on Banking Supervision.

The management of risk in a financial institution consists of three elements: first, the accurate measurement and monitoring of risk; second, controlling and pricing exposures; and third, the holding of adequate capital and reserves to meet unexpected losses. The trend in supervisory oversight in recent years has been to work on each of these aspects. Numerous papers from the Basel Committee have provided guidance to best practice in the management of the various risks confronting managers of financial institutions: credit risk; interest rate risk; operational, legal and other risks. At the same time, as is well-known, supervisors have been refining the measurement of the amount of capital that is needed to provide an appropriate cushion against these risks.

The first Basel Accord, in 1988, was a major step forward in that it introduced the concept of "risk-weights" to help judge the amount of capital a bank needs to underpin a given portfolio. The latest proposals from the Basel Committee take this a further important step forward, in two respects. First, the measurement of risk-weights is refined, to be more reflective of actual risk. Indeed, subject to strict safeguards, banks will be able to use their own credit assessments, rather that the crude "risk-buckets" which is the best that can be achieved by an external assessment. Second, the new accord foreshadows greater reliance on two additional "pillars" for capital adequacy; supervisory review and market discipline. This brings me to the next major trend in supervision and regulation that I want to talk about.

3. The increased use of supervisory oversight and market discipline

The title of this session is "International trends in Banking Regulation and Supervision". But one of the important trends has been, and continues to be, a move away from regulation, and towards supervision - a move, in other words, away from compliance with portfolio constraints, and toward an assessment of whether the overall management of a financial firm's business is being prudently conducted. At the same time, greater attention is being given to disclosure, to allow markets and counterparties to better control excessive risk-taking.

There are several reasons why old-style regulation is being adapted to the new realities of the market place. In the first place, the rapid development of new instruments and methods of risk management make mechanical application of balance sheet ratios inappropriate. Secondly, regulation inevitably creates incentives for financial engineers to find a way around the rules. More generally, regulation is too blunt an instrument to capture the technicalities and the sophistication required to control risk in a complex financial organisation.

Supervisors have to understand all aspects of a financial firm's business, and to foresee the multiple sources of risk it is likely to confront. This means that supervision is becoming a more demanding profession, and the skills required of supervisors are becoming greater and more diverse. Accounting and legal training, while important, are no longer enough. Supervisory authorities are going have to seek also staff with backgrounds in economics and business management. Supervisors are becoming more like consultants, whose task is to understand the bank's business and draw management's attention to underappreciated sources of risk.

4. The importance of financial infrastructure

The financial sector does not exist in a vacuum. Its efficiency and stability depend, not only on the prudential standards applied by financial institutions, but on the robustness of the financial infrastructure that underpins transactions. By that, I mean the legal and judicial framework, the accounting standards used to value financial assets, the availability of relevant statistics; the payment and settlement system; principles of corporate governance, and so on.

Weaknesses in the financial infrastructure can render useless the most careful supervisory oversight. Contracts need to be enforceable with reasonable predictability. Thus, the legislation needs to be in place, and impartially enforced. A particularly important area is insolvency arrangements. All contracts should foresee the possibility that one party is unable to perform under the contract, and give the other party a predictable and timely recourse. Absence of fully satisfactory bankruptcy arrangements has been an important factor retarding market development, and intensifying financial crises, in a wide range of countries, including Mexico. A specific issue is the ability of creditors to seize and dispose of collateral in the event of default.

Accounting practices are another major source of problems in many jurisdictions. Capital ratios do not mean very much if a bank's lending portfolio is inappropriately valued. And market discipline dependent on disclosure and transparency will be largely ineffective (if not distorted) if faulty accounting masks the true state of balance sheets.

5. The need for a level playing field

The globalisation of financial activity makes a global approach to financial supervision essential. In the absence of a global approach there would be the twin dangers of competition in laxity and regulatory arbitrage. Competition in laxity occurs when jurisdictions consciously lower regulatory requirements to attract business. And regulatory arbitrage is the other side of this coin - the search by financial institutions for jurisdictions in which the burden of regulation is lightest.

A possible approach to this problem would be to set up a world financial authority, with powers to set and enforce regulations worldwide. Some indeed have advocated the creation of such a body. I do not believe such an approach would be either feasible or desirable. It is not feasible, since there is very little chance of sovereign legislatures ceding powers in the regulatory area to a supranational body. And it would not necessarily be desirable either. A single regulator could well be too monolithic, disinclined to experiment with new regulatory approaches. The rules it would create might not take adequate account of the particularities of the financial sector in different jurisdictions. And insofar as all countries had to agree on regulatory initiatives, there would be a risk of converging on the lowest common denominator.

The most promising approach is that adopted by the Basel Committee on Banking Supervision, and followed by a number of other standard-setting bodies. It is to draw up a set of standards that can be agreed by supervisors in the most advanced jurisdictions, whose broader adoption is encouraged by peer pressure and market forces. It is remarkable to note that the Basel rules are backed by no formal legislation, nor has the Basel Committee any legal existence. Yet the recommendations of the Basel Committee have greater force than many Treaty-based agreements.

Of course many issues remain. One is to ensure that rules made by a restricted group are adequately responsive to the circumstances of countries that are not members of the standard-setting group. This can be achieved by a process of consultation and review, in which a much wider range of countries is involved. Another issue is implementation. How can countries be encouraged to adopt the measures that will strengthen their financial systems? Here the answer seems to be to seek greater support from the market. If markets reward high standards by easier access to funds at lower costs, there is little doubt that strong internal pressures would be created to improve standards.

Perhaps it is appropriate here to say a word about the Financial Stability Forum. The Financial Stability Forum was created in 1999, and includes senior representatives of ministries of finance, central banks and regulatory authorities in the major financial markets, as well as representatives of the main international organisations and standard setting bodies. One of the reasons for setting up the forum was a realisation that there are many bodies whose activities contribute to financial stability and who have a stake in its preservation.

The Forum, in other words, is a tangible recognition of the fact that financial stability requires vigilance in a number of dimensions. Individual financial institutions have to be run on prudent lines, markets have to be open and transparent, and the financial infrastructure has to be robust. All of these objectives have to be pursued at a global level, since the financial industry is global and capital markets are increasingly integrated. Yet there is no global authority that can act in all the areas that are required. The Forum helps to fill this gap, by facilitating the coordination of efforts by the numerous separate authorities having responsibilities in the field of financial stability.

6. Marrying the micro- and macro-perspectives in regulation and supervision

Let me end these remarks with some brief reflections on the relationship between macro-economic stability, which is traditionally seen as the responsibility of the monetary authorities; and micro-economic stability which, in the financial sector, is traditionally seen as the responsibility of prudential supervision. I believe we are coming to realise that the nexus between these policies is closer and more complex than we once imagined.

Supervisors are growingly aware that generalised financial instability usually has its roots in macroeconomic factors. Banks do not often get into serious difficulties all by themselves. And if they do, we usually have remedies to hand. Crises typically occur because banks are jointly exposed to a common macroeconomic shock. This is often related to the financial cycle.

Realising this, supervisors are searching for techniques that will make banking systems more resilient to the financial cycle. Banks need to be encouraged to build up capital cushions in good times so that they are available to protect their lending when the cycle turns down. That way, they would be better prepared to weather bad times. By the same token, they would also lessen the risk that the credit cycle would unnecessarily exacerbate the economic cycle and hence the risk of financial distress. Among such techniques are stress-testing, pre-provisioning, cyclically variable loan to value ratios, and so on. The strengthening of the supervisory review process (Pillar 2) envisaged in the new Basel Capital Accord could provide a sounder basis for promoting these practices.

Monetary authorities, too, will have to recognise the complex two-way relationship between monetary and financial stability. The seeds of future financial instability are usually sown by excessive credit expansion. This facilitates the build up of leverage in the financial system and exposes institutions to losses when the credit cycle turns. Monetary policy will have to be conscious of the risk of accommodating excessive credit expansion and the unsustainable rise in asset prices that often accompanies it.

In summary, prudential regulation is becoming more complex and demanding, as well as more important and more fascinating. It is bringing together multiple disciplines in an attempt to harness the forces of the market to improve the market's stability. The new Basel Capital Accord is one manifestation of this evolving approach. It stresses greater risk sensitivity, flexible supervision, and more reliance on market disciplines. It is, of course, no more than a further important step along the road to a more efficient and resilient financial system. But it is an important step. And it will work for the benefit of us all.