Banking and insurance regulation and supervision: Greater convergence, common challenges

Speech delivered by Malcolm D Knight, General Manager of the BIS, at the International Conference of Banking Supervisors, Madrid, 22-23 September 2004.

It is a great honour and pleasure for me to have been invited to speak at this biennial event - an event that has become a regular highlight in the calendar of banking supervisors from all over the world. And it is a particular pleasure to do so at a time when a major landmark in the long journey towards a safer and sounder global banking system has just been reached. I am of course referring to the new Basel capital adequacy framework. I have little doubt that, looking back, Basel II will be recognised as a critical milestone in our efforts to build a prudential framework that is strong, that works with market forces and that is sufficiently flexible to be adapted to country-specific circumstances as well as to the further evolution of the financial industry that no doubt is in store.

In my remarks today, however, I would like to cast my gaze more broadly and examine a number of implications of that never-ending evolution of the financial industry. In particular, I would like to explore with you the implications for the framework of prudential regulation and supervision of a deceptively simple word: "convergence". What I have in mind is the historically unprecedented process of convergence within the financial industry along three dimensions -- between financial institutions and capital markets; among different types of financial institutions; and among different national jurisdictions. My main focus will be on banking and insurance, where some of these forces have recently become more prominent, so that they pose major questions for those in charge of securing safety and soundness.

Convergence naturally implies shared interests and common challenges. In what follows, I will illustrate this obvious point in two ways. First, I will take a brief look back at how convergence has already shaped the parallel policy responses of banking and insurance supervisors. Then I will look forward and examine two emerging common challenges that will loom large in the coming years. One such challenge is to ensure that accounting standards and prudential frameworks are mutually consistent. This is necessary in order to achieve, simultaneously, the twin objectives of providing an accurate picture of the financial condition of a firm on the one hand, and of instilling the desired degree of prudence in its behaviour on the other. A second challenge is the need to strengthen the "macroprudential" or system-wide orientation of prudential frameworks, going from general principles - over which a growing consensus is forming - to practical day-to-day implementation. This is necessary to reinforce our safeguards against financial instability. In both of these areas, I will try to suggest ways in which we could make further progress.

A common thread in my remarks today is that the challenges posed by convergence highlight the importance of cross-fertilisation of different perspectives. In particular, there is much that banking and insurance authorities can learn from each other. And this dialogue should be embedded in a broader one encompassing other groupings too, notably accounting standard setters and central bankers. We are often tempted to highlight what makes us special rather than what we have in common. As a result, we can easily overlook those characteristics that bring us together and, in the process, fail to leverage our mutually reinforcing areas of expertise. We should build on these shared foundations to reach a common understanding of the problems and a common solution to them.

I - The backdrop: greater convergence

By now we are all familiar with the broad contours of the powerful process of convergence that has been shaping the global financial industry over the past two decades. The forces of financial liberalisation, technological advances in elaborating and disseminating information and pricing complex financial instruments, and breakthroughs in financial risk management have made themselves felt across financial institutions and markets, across different types of financial institution and across national jurisdictions.

First, the respective roles of capital markets and of financial institutions have been converging. Markets have made major inroads in the allocation of both funds and risks within the economy. They are now a key supplier of credit, they provide traditional insurance services, and they transfer risks across segments of the financial system, not least through derivatives. Initially, derivatives addressed market risk; now, the unfolding revolution is in instruments to manage credit risk. Crucially, in the process, the dividing lines between market traded and non-traded financial instruments and between insurance and other types of financial instruments that provide protection from specific risks have become increasingly blurred. Moreover, the relationship between markets and institutions has grown increasingly symbiotic. On the one hand, institutions rely more and more on markets for their funding, for their investments and for the management of risks. On the other hand, markets rely more and more on institutions for their liquidity, drawing on market-making services and backstop credit lines.

Second, different types of financial institutions have been converging. This has been true even as the financial landscape has become more diverse. Many commercial banks have come to resemble investment banks as a growing proportion of their business has been channelled through the capital markets. And the growth of conglomerates that encompass both banking and insurance has eroded the long-standing barriers that had kept these two lines of business apart.

Third, financial arrangements across different national jurisdictions have been converging - a process that most of us know as "financial globalisation". As obstacles to capital flows, foreign establishment and the cross-border provision of financial services have come down, the pressure to adopt similar arrangements across countries has grown.

These powerful forces of convergence have been mirrored in developments in risk management and in the prudential frameworks adopted by national authorities.

With risk management evolving from a side constraint on financial activity to a core function underpinning that activity, the similarities between the risks faced by different institutions have become increasingly apparent. In the process, the "language" barriers that used to separate the analysis of risks in different lines of business as well as in strands of academic thinking have slowly been breaking down. For example, a moment's reflection is sufficient to realise that Value-at-Risk measures that are common in banking and the stochastic asset-liability techniques that are common in insurance are, conceptually, the same sort of tool; they differ primarily with respect to the instruments included in the analysis and the horizon used for assessing risk.

This recognition has gone hand in hand with efforts to move towards a more integrated firm-wide approach to risk management. Across business lines, this means managing the same risk in the same way regardless of its location in an enterprise. Across different types of risk, it means developing a common metric for the aggregation of risks and for the calibration of economic capital. Clearly, even cutting-edge enterprises are a long way from achieving either objective. The broad direction, however, is unmistakable.

Likewise, prudential frameworks have been converging along different dimensions. Across national jurisdictions, it has become increasingly difficult to pursue country-specific solutions. International cooperation through the establishment of common standards, initially spearheaded in banking by the Basel Committee, has subsequently encompassed other regulatory groupings too, first securities regulators and then insurance supervisors. Across functional lines, the differences in approach have narrowed. For instance, capital adequacy, supervisory review of risk management processes, and enhanced public disclosures are all core elements of the prudential frameworks for both banking and insurance. The trend towards convergence has been strengthened by the establishment of "integrated supervisors" in a number of countries and, internationally, by the creation of the Joint Forum. The Forum has been performing a valuable role in identifying differences in prudential arrangements across sectors and in considering the ever larger set of issues of common interest across the different supervisory communities.

As an outside observer, I have always been struck by how much prudential authorities in banking and insurance can learn from each other, once the unfamiliarity with their respective approaches is overcome. Let me illustrate with a couple of examples. Insurance regulators have learned to focus on the risks to financial soundness that arise from the asset side of balance sheets, as opposed to focusing exclusively on the underwriting risks associated with insurance liabilities. For their part, banking supervisors are beginning to pay more attention to the adequacy of pricing policies in covering expected losses - which is a long-standing practice in insurance. I think that this is an area that will require much more attention in future. The message is that cross-fertilisation between the two communities of standard setters should be encouraged.

Against this background it is not surprising if the challenges faced by the two supervisory communities are increasingly shared ones. The financial reporting and macroprudential challenges that I highlighted at the beginning are the result of the same convergence forces that have been shaping the work of prudential authorities in other areas. And while I tend to place them primarily in the future, I do so simply because I feel that they will intensify in the years ahead. The future has in fact already started. Let me explore each challenge in turn.

II - The financial reporting challenge

Global financial markets - the epitome of the forces towards convergence -- naturally go hand in hand with global financial reporting practices. This is the rationale for the intense efforts that are under way to establish a common set of internationally accepted financial reporting standards (IFRS). There is a broad consensus over the importance that such standards can have for the proper functioning and stability of the financial system. Alongside core principles for prudential frameworks in banking and insurance, accounting standards are now part of the set of twelve standards that have been identified by the Financial Stability Forum as conducive to a robust financial infrastructure.

But it is one thing to agree on the importance of common financial reporting standards, and quite another to agree on a specific set. The development of international financial reporting standards has brought to the fore important differences in perspective between accounting standard setters on the one hand, and prudential authorities on the other, that will need to be reconciled. The stakes are high.

The first step in establishing a sound basis for this reconciliation is to understand the deep reasons for the differences of perspective. No doubt many factors are at play. After all, differences of opinion exist also within the two communities of standard setters. Even so, at the cost of some oversimplification, I would trace the reasons to differences in objectives and in approaches.

As regards objectives, accounting authorities have increasingly been seeking to establish "unbiased", or "true and fair", pictures of the financial condition of firms. This has meant departing somewhat from a time honoured accounting tradition that had leaned more towards conservative assessments of a firm's financial condition. As regards approach, accounting standard setters view the financial accounts as having to reflect the outcome of "past transactions and events". De facto, this has meant that in certain cases they have continued to stress the backward-looking elements of accounting statements of the financial condition of firms. By training, accountants and auditors are less at ease with risk concepts and risk measurement techniques. Consequently, they may on occasions set the bar for the verifiability of financial statements quite high when risk management questions are at play.

By contrast, the objective of financial supervisory authorities is to instill prudence in the behaviour of the firms they supervise. As a result, they are more naturally inclined to favour conservative valuations, often because these are seen as providing helpful safety cushions. As to approach, prudential authorities focus very much on prospective rather than past outcomes; risk is inevitably a forward-looking concept. And since the assessment of risks is the essence of their business, they may also be more disposed towards accepting verifiability thresholds that may appear insufficiently stringent in the eyes of their accounting counterparts. This is especially the case whenever the thresholds are seen as consistent with prudent risk management practices.

Let me clarify and illustrate. In banking, prudential authorities would like accounting standards to accommodate more forward-looking provisioning, since current rules are often seen as too backward-looking. Likewise, they would like to have greater flexibility to allow firms to macro-hedge their risks, a process that is rather foreign to their accounting counterparts because it runs counter to the principle of valuing assets and liabilities on an individual, as opposed to a portfolio, basis. In insurance, similar issues arise in the context of the valuation of renewal policies. Valuing them on the basis of an expected rate of renewal is common practice among actuaries, but not among accountants. The analogy with the valuation of core bank deposits is obvious.

What, then, about the way forward? Here, I think it is useful to distinguish between the long run goal, on the one hand, and the transition towards it, on the other.

As regards the long-run goal, we need to clearly keep in mind the different techniques and approaches that accountants and supervisors use, even though their ultimate goals are highly complementary. In other words, it seems natural for accounting to seek to portray the best approximation to an "unbiased" and comprehensive picture of the financial condition of the firm while prudential regulation seeks to instill the desired degree of prudence in its behaviour on the basis of that portrayal. Ideally, this would call for a unique set of valuations rather than one for accounting and another for prudential purposes. And it would mean avoiding the expedient of setting safety cushions or buffers through conservative accounting per se. This would have the benefit of greater transparency, of avoiding the risk of unwittingly undermining either of the two objectives, and of facilitating convergence in accounting standards across both sectors and countries.

At the same time, it is essential that at all stages during the transition towards this long-run goal, the prudential authorities be in a position to redress any adverse implications that the needed changes in accounting standards may have for the safety and soundness of regulated financial intermediaries. In other words, the transition should be properly co-ordinated. For example, to the extent that an uneven recognition of fair value principles across asset categories might introduce artificial volatility in the accounts, prudential authorities should be in a position to counteract its impact on financial stability. While this issue has attracted considerable attention in banking, it is just as important, or perhaps even more important, in insurance.

Having said this, it is important to recognise two additional points about the final framework and the process towards it, respectively.

First, the portrayal of the financial condition of the firm should cover not just its profitability, cash flows and balance sheet, as it does today, but also its risk profile. This is an area where prudential authorities have taken the lead, by encouraging greater risk disclosures by regulated firms. Pillar 3 of the new Basel capital adequacy framework is the latest such example. The need for disclosure of risk information is beginning to be recognised by the accounting standard setters too; the IASB has launched a project in this area. The prudential standard setters are ideally placed to make major contributions to the development of such risk disclosure standards. And these efforts should be pursued vigorously.

Second, the contribution that prudential authorities can make to the development of standards goes well beyond providing more information on the risk profile of firms. We have all come to recognise that valuations and risk assessments are inextricably intertwined. Since economic agents care deeply about risk, the way current and prospective income streams are valued inevitably incorporates perceptions of risk as well as attitudes towards risk - commonly known as "risk appetite". It follows that prudential authorities can also bring precious value added to the rules for the compilation of traditional accounting information. Consistency between risk management practices and valuation is essential.

I am optimistic that, over time, we will make progress in the direction I have just outlined. Indeed, progress is being made as I speak. While much still needs to be done, the dialogue between prudential and accounting standard setters has become ever more intensive in recent years. I hope that it will become closer still in future, ideally through tighter institutional arrangements. Indeed, I am convinced that this dialogue will foster a greater understanding of the differences in perspective between accounting and prudential authorities, as well as greater convergence on the basis of shared perspectives and a "common language".

III - The macroprudential challenge

Next, what about the macroprudential challenge? Some of you may recall the keynote address delivered four years ago by my predecessor, Andrew Crockett. On that occasion, he argued that in order to improve safeguards against financial instability it was desirable to strengthen the macroprudential orientation of prudential frameworks, with respect to both the identification of vulnerabilities and the calibration of policy instruments. In practice, this would mean two things. First, shifting the focus somewhat from the safety and soundness of individual financial institutions to that of the financial system as a whole. Second, recognising more explicitly that while individual institutions may treat the underlying determinants of risk as independent of their actions, they can, collectively, have a first order effect on the determinants of risk themselves. For instance, lending booms can boost economic activity and asset prices to unsustainable levels, sowing the seeds of subsequent instability. Likewise, if a large number of financial market participants assume that markets will remain liquid even under collective selling pressure, they could be induced to overextend their position taking, thus generating the very pressure that would cause markets to become illiquid.

There are at least two reasons why a macroprudential perspective is important.

First, experience has shown that the financial crises that have the most serious costs for the economy tend to arise from shared exposures to risks -- typically macro risks -- rather than from individual failures that are due to institution-specific factors. This has been true both in banking and insurance. In banking, examples of these macro-financial risks include the banking crises in Nordic countries following financial liberalisation in the late 1980s, those in Japan in the early 1990s, and, more generally, those in several East Asian and Latin American economies at various times over the past twenty years. In insurance, the recent Japanese experience is equally relevant.

In addition, the convergence observed within the financial industry has made such a system-wide perspective more compelling, as risks are more easily shifted across institutions and markets. For instance, in the period of global economic weakness that began in 2001, insurance companies fared far worse than banks precisely because banks had restrained their lending during the preceding boom. Instead, much corporate funding had been channelled through the capital markets, with insurance companies, for example, investing heavily in both bonds and equities. In addition, the possibility of shifting risks through the rapidly growing and less transparent credit derivatives markets has also played a role, although quantitatively a less important one so far.

By now, the importance of the macroprudential perspective as a complement to the more traditional microprudential focus is widely recognised. As a result, steps have been taken to put it into practice, both with respect to the identification of vulnerabilities and in the calibration of policy instruments.

As regards the task of identifying vulnerabilities in the financial system, macroprudential analysis is now routinely carried out in various guises. It is an integral part of Financial Sector Assessment Programs implemented jointly by the IMF and the World Bank. It is also a regular element of the monitoring exercises done in international fora, notably at the Financial Stability Forum and at the BIS-based Committee on the Global Financial System. And it is more or less institutionalised in some national jurisdictions. Moreover, regular financial system monitoring has been complemented from time to time by more in-depth analysis of structural developments in the financial sector. The most obvious example is the set of studies done or under way on the impact of credit risk transfer instruments on the allocation of credit risk across the financial system, including by the Joint Forum.

As regards the calibration of prudential policy instruments, it is possible to find signs of a greater awareness of a macroprudential perspective in both banking and insurance. In banking, one such illustration is the various adjustments made to Basel II, partly with a view to addressing concerns about procyclicality. In insurance, one could point to the decision by the UK FSA in the autumn of 2002 to relax the stringency of stress tests so as to avoid the destabilising impact of cascading distress sales on the stock market.

I expect that these trends towards strengthening the macroprudential orientation will continue. My sense is that we are at the very beginning of the process. There is still much that we need to learn about the identification of system-wide vulnerabilities and the calibration of policy instruments. And, to my mind, the basic principle that the framework should be designed to ensure that sound risk management practices lead to cushions that are built in good times so as to be run down, up to a point, in bad times, has not yet gained the currency that it deserves. I suspect that the merits of this principle would appear more obvious if fair value elements in accounting became more prevalent.

In achieving the shift towards a stronger macroprudential orientation, an even closer dialogue between central banks and prudential authorities will be especially helpful. After all, a macroprudential perspective is part of the DNA of central bankers, who can bring to the table the multifaceted expertise honed through the discharge of their monetary policy responsibilities. This dialogue has a long tradition, but I suspect that it will become even more important in future.

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To conclude, let me just reiterate the key message. I have argued that the broadly-based process of convergence within the global financial system across markets, institutions and national jurisdictions puts a premium on a shared understanding of problems and on a shared formulation and implementation of solutions. I have illustrated this simple point with two challenges shared by banking and insurance supervisors, namely the need to ensure that accounting standards and prudential frameworks are mutually consistent, and the need to strengthen the macroprudential orientation of supervisory arrangements. In these, as in other areas, while much has been accomplished in recent years, there is clearly scope to intensify and broaden the dialogue within the financial policymaking community.

Indeed, in the balance of its own activities, the BIS has felt the convergence forces just as strongly as market participants and policymakers have. Since its inception, the hallmark of our institution has been to support the international dialogue within the policy community. Over time, that function has been extended from central banks to prudential authorities, first in banking and more recently, albeit more indirectly, in insurance. Thus, we are replicating in the small the much larger shift in the world around us. Peering into the future, it is both my hope and expectation that the dialogue will continue to intensify and broaden. It would be a small but tangible sign that progress is being made.

Thank you.