Global banking - paradigm shift

Speech by Malcolm D Knight, General Manager of the BIS at the Fourth Conference of the Federation of Indian Chambers of Commerce and Industry (FICCI), Mumbai, India, 5 October 2005.


Mr Knight discusses three important issues that are relevant to global banking: how market developments have shaped bank behaviour over time and elicited appropriate responses from financial sector supervisors; how market contestability is important for improving market efficiency in the changing environment; and how some degree of harmonisation of standards internationally is necessary to facilitate effective market discipline.

Full speech:

1. It is a great pleasure to be here today to deliver the inaugural address at the fourth Annual Conference of the Federation of Indian Chambers of Commerce and Industry (FICCI). The last time I participated in the FICCI Conference was in September 2003. The theme then was "Indian banking - global benchmarks". Today it is "Global banking - paradigm shift". This subtle change of emphasis in themes - from Indian banking to global banking - clearly reflects today's reality: the increasing globalisation of the Indian economy.

2. Over the past decade, India has emerged as one of the fastest-growing economies on the globe. The rest of the world has been impressed to see that the reforms initiated in the early 1990s are bearing fruit. To sustain any country's growth, of course, a strong and dynamic financial sector is essential. What can governments and central banks do to nurture a more efficient and competitive financial industry and at the same time maintain the stability of the system as a whole? This question is central to the international deliberations on financial policy that take place at the Bank for International Settlements.

3. The BIS and its various committees of experts play a major role in shaping the policies, standards and so on that help to ensure global financial stability. Let me therefore begin by mentioning a few of these important committees and groups. One is the Committee on the Global Financial System (CGFS). This Committee regularly monitors the latest developments in financial markets worldwide, and also investigates how structural changes affect the working of the global financial system. Representatives of the Reserve Bank of India are active participants in the work of the CGFS. Another key committee is the Basel Committee on Banking Supervision, with which many of you will be familiar. The Basel Committee formulates broad supervisory standards and recommends guidelines for sound practices in the areas of banking system supervision and regulation. The Basel Committee does not enforce compliance with the standards it issues. Rather, the expectation is that national authorities will take steps to put in place the necessary arrangements, statutory or otherwise, that are best suited to their own national systems.

4. The BIS Financial Stability Institute (FSI) helps financial sector supervisors to implement these standards and so strengthen their financial systems. A large number of conferences, high-level meetings and seminars are held by the FSI in Basel as well as in different regions around the world. The FSI also offers an online learning tool - FSI Connect - that is helping to train banking supervisors in some 95 jurisdictions around the world.

5. What I would like to underline is that these committees, the FSI and the BIS generally have deepened their contacts with the financial industry in recent years. The Basel II process provides one recent obvious instance. This revision of banks' capital adequacy requirements was undertaken over a period in which consultation with the private sector - throughout the world, not just in the main financial centres - was intense and continuous. This dialogue between the private sector and the official sector is becoming more and more important. And this is why conferences such as this one can be so stimulating and productive.

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6. In the rest of my talk today, I want to concentrate on three themes related to the interface between the financial markets and various elements of the regulatory framework that I believe are relevant to global banking today.

The first theme is:market forces and the rationale of Basel II. Because global market forces are increasingly shaping the structures of national banking systems, supervision needs to be conducted in ways that harness market discipline.

The second is:the importance of market contestability. Technological developments and international agreements on financial services are making financial markets ever more contestable.

The third is thateffective market discipline depends on the harmonisation of standards. Global integration is creating a need for some degree of harmonisation in this area.

My first theme is:

(i) Market forces and the rationale of Basel II

7. Technology, deregulation and liberalisation have reinforced market competition, locally and internationally. Banks now have significant operations beyond their domestic borders and are handling a large amount of business and millions of non-resident clients across the globe. In the process, large, internationally active financial institutions with complex risk profiles have grown in size. Other domestic banks and institutions are also forging stronger cross-border linkages by acquiring customers abroad. Three related changes have also been important.

8. One: in the past, it was frequently the regulators who directly limited banks' business and risk-taking and - very often - shielded banks from competition. Now banks across various jurisdictions are able to take most of their own decisions - and face the consequences. They also have to withstand more competition. These developments have inevitably focused the minds of senior bank managements on the significance of managing risks.

9. Two: the economic context in which banks operate has changed. There is an increasing emphasis on "shareholder value", which leads banks to focus on improving risk-adjusted profitability, rather than simply boosting business volumes. Banks are more aware of risks in their business and of the need to use their scarce capital resources effectively. They constantly develop and seek to improve sophisticated tools for assessing, monitoring and managing risks.

10. Three: banks now face increased competition from the alternative sources of finance that open capital markets provide. At the same time, various capital market instruments are now available to banks that can help them to manage their risk profiles in a more flexible manner. Banks not only need to price their products based on a better assessment of risks, but they also need to really understand the advanced products that are available to mitigate or manage risks.

11. All these market developments are forcing banks to take a closer look at their risk management systems and procedures as they seek to better manage their business in a changing global banking scenario. What the international standard setters and regulators are trying to do is to devise mechanisms of regulation and oversight that are well adapted to this new environment. As the market and business environment evolves, so also must the international regulatory framework.

12. Basel II is an important step forward in this direction. The basis for Basel II was already provided by the 1988 Capital Accord, often referred to as Basel I. Basel I has become widely used - indeed more than 100 countries around the world have implemented this standard. In the light of the market developments that I have just mentioned, however, Basel I has become outdated, especially for the large, sophisticated banks. It is also not sufficiently risk-sensitive for the more competitive and more complex banking business that has emerged over the past decade.

13. The three pillars of Basel II represent a much more comprehensive approach to the greater complexity of present-day banking. As you know, Pillar I covers capital adequacy requirements. Under Pillar II, supervisors will review not only a bank's calculation of its need for capital, but also how the bank manages a wide array of risks. Third, but by no means least, Pillar III will ensure that banks achieve the high standards of public disclosure that are needed for market discipline to be effective.

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The importance of market discipline brings me to my second theme:

(ii) The importance of market contestability

14. I need hardly remind this audience that technology and international agreements on financial services have already made global banking a reality in many countries, and are increasingly doing so in many others. This means that countries need to ensure that their banking and financial markets can adapt to a more competitive environment. The "contestability", or "competition-friendliness", of a market is the key issue here. The degree of contestability varies directly with how easy it is for new firms to enter the market. The regulations that govern actual operations also shape contestability. Increased competition enables the provision of a broader range of services, reduces price distortions and cuts costs for firms and households. It also helps to transfer new technology and skills into the market, as well as new products and management techniques, which improve the overall efficiency of the market.

15. Contestability has various dimensions. Domestic institutions must feel some impetus to achieve greater efficiency and new banks should be allowed to access the market and compete without significant regulatory constraints. The partial privatisation of public sector banks in India - involving a substantial injection of private shareholding - has been a notable step forward. So too has the establishment of 12 new private sector banks since 1993.

16. Foreign direct investment (FDI) in the financial sector is also very important. A recent comprehensive report by the CGFS found that local banks' exposure to global competition boosted the efficiency of the local financial sector in a lasting way. Competition from foreign firms forces local banks to reassess their lending practices. The result has often been better risk management1and more diversified lending portfolios - and hence safer banks. The steps taken by India in recent years to allow greater FDI in domestic private sector banks and to permit the establishment of foreign banking subsidiaries in India are therefore to be welcomed.

17. It needs to be recognised, however, that managing foreign bank involvement in the domestic financial system isa challenge. BIS workshops held in Asia, Latin America and eastern Europe brought to light several important dilemmas that policymakers face.2A common theme of these workshops was that good communication between home and host country authorities in charge of financial sector oversight was essential. But the issues raised were much broader than just information exchange between supervisors. Aspects such as the availability of market information and the effectiveness of market discipline, corporate governance, coordination in crisis situations and emergency liquidity assistance were all considered to be of great importance. Again, dialogue between the public and private sectors on these issues would be particularly fruitful.

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(iii) Harmonisation of standards

18. Now let me turn to the last of the three themes: that effective market discipline depends on the harmonisation of standards. As barriers to the establishment of foreign banks and to the cross-border provision of financial services come down, increased attention is being given to the harmonisation of accounting standards and arrangements across countries. Harmonisation does not mean homogeneity. Rather, it implies a necessary degree of commonality in standards to ensure competitive equality. This is not a goal that is easily attained. The fundamental challenge is to find sufficient common ground for an international framework that promotes broadly consistent results - or a "level playing field" - in the face of the very real differences that exist across countries in terms of legal systems, market practices and business conditions. Finding such common ground invariably involves compromise, which means that the result is unlikely to be that which a country acting on its own would have adopted.

19. The process of harmonisation of accounting standards began several years ago and is being coordinated by the International Accounting Standards Board (IASB). I am a trustee of the IASB, and this work is close to my heart. A number of international financial reporting standards (IFRS) have been finalised and have been applicable to all listed companies in the European Union since 1 January 2005. Several other countries have also adopted IFRS as their national accounting standards. It is estimated that more than 90 countries will either permit or require the use of IFRS before or during 2007 for publicly traded companies.

20. In addition, a number of other countries are putting in place a formal policy to bring their national standards into line with IFRS. The Securities and Exchange Commission of the United States has also expressed strong support for convergence between IFRS and the United States' Generally Accepted Accounting Principles (US GAAP). The Financial Accounting Standards Board (FASB) of the US and the IASB are now working towards finding common ground between IFRS and US GAAP.

21. As I understand it, many of the Indian commercial banks currently prepare their statements under US GAAP, in addition to adhering to Indian accounting standards. Convergence between Indian and international accounting standards has been adopted as a formal policy of the Institute of Chartered Accountants of India. Moreover, India has been involved in the Standards Advisory Council of the IASB, which meets periodically to inform and advise the IASB on various issues relating to accounting standards. All this is welcome.

22. Adopting common financial reporting should be a major step towards improving the efficiency of international financial markets. It will reduce barriers to both trade and the flow of capital. Investors will have access to more reliable financial data to assess corporate performance in many jurisdictions. As issuers of securities, companies will be able to attract investors more easily, potentially reduce their cost of capital, and save the costs of having to conform to many different requirements in different jurisdictions. Audit firms will be better able to assure the quality of audits among national partner firms. Financial sector supervisors and regulators will benefit from the greater consistency and quality of information. Ultimately, the adoption of such common standards will lead to increased opportunities for global investment, and will boost employment and growth globally. Not surprisingly, then, there is growing momentum in the adoption of IFRS across jurisdictions.

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23. Let me conclude what I have been saying this morning by summarising three main issues. First, global banking is becoming a reality in more and more countries. Financial firms are operating in an increasingly open, global and competitive environment. Banks have to adapt to an environment that makes effective risk management all the more important. Supervisory oversight also needs to continuously evolve to keep pace with market changes. Basel II is an important step in this direction.

24. Second, greater domestic and foreign competition can lift the efficiency of local banks and other financial institutions. This is a development to manage, but not to impede.

25. Finally, accounting standards need, as far as possible, to become more harmonised internationally. The work of the IASB is therefore of major importance in helping market discipline to work effectively.

26. A conference such as this one is very welcome because it contributes to the necessary dialogue between private firms and regulators. And it helps us keep our eyes open to new developments in the markets.

1 Foreign direct investment in the financial sector of emerging economies, CGFS Papers, no 22, March 2004.

2 The different views are summarised in Foreign direct investment in the financial sector - experiences in Asia, eastern Europe and Latin America, CGFS Papers , no 25, June 2005.