Global Banking: paradigm shift - towards meeting the emerging challenges

Special address by Mr Malcolm D Knight, General Manager of the BIS, at the Inaugural Session of the Fifth Federation of Indian Chambers of Commerce and Industry (FICCI) - Indian Bankers Association (IBA) Conference "Global Banking: Paradigm shift - towards meeting the emerging challenges", Mumbai, 26-28 September 2006.

Abstract

Three issues are of particular importance in the context of maintaining financial stability at the national and global level. First, global banking will flourish in a strong and stable financial environment. Effective cross-border cooperation arrangements will provide strength and stability to financial systems nationally and globally. Second, adoption of sound corporate governance practices by all the entities in the financial system will improve the robustness of national and global financial systems. Third, accounting standard setters and prudential standard setters need to develop an understanding of each other's approaches. Their cooperation will result in a step forward towards maintaining financial stability.

Full speech

1. It is a great pleasure to be here once again to address the participants at the fifth Annual FICCI-IBA Conference. I have participated in the conference on two earlier occasions, in 2003 and 2005, and I find it interesting to note how the core theme of the conference has evolved over the years. The change in the theme from "Indian Banking - Global Benchmarks" in 2003 to "Global Banking - Paradigm Shift" in 2005 was indicative of India's well orchestrated move towards integration with the global banking markets. This year's theme, "Global Banking - Paradigm Shift - Towards Meeting the Emerging Challenges", adds a further dimension: that of ensuring preparedness to meet the challenges on the path to globalisation.

2. The steady pace of economic growth that India has maintained, along with monetary and financial stability and a gradual and sequenced approach towards liberalisation and globalisation, has been quite impressive. India's commitment to implementing international sound practices in the financial sector is also commendable. India is an active member in the various global economic and financial stability discussions, as well as in the international sound practice consultations that are held by the Bank for International Settlements (BIS) in Basel and elsewhere.

3. Global banking can function efficiently and effectively only in an environment of financial stability. Due to the increasing interlinkages between the national and the global financial systems, maintaining financial stability is a complex task today. The stability of various national financial systems plays a significant role in maintaining global financial stability, just as the stability of individual institutions and markets facilitates financial stability at the national level. In my talk today, I will touch upon some aspects that are crucial to maintaining financial stability at both the national and global levels.

4. Before that, however, I would like to talk briefly about how the BIS is contributing to ongoing efforts related to financial stability. The mandate of the BIS includes, among other things, fostering international monetary and financial cooperation. In fulfilling this mandate, the BIS serves as a forum for, and facilitator of, meetings and discussions among experts from central banks and financial supervisory agencies, and in recent times also from the private financial sector. The BIS also provides support to various committees and groups of financial sector experts that are engaged in setting sound standards in areas such as banking supervision, insurance supervision, payment and settlement systems, and financial stability. The Financial Stability Institute (FSI) of the BIS is the standards disseminator and facilitator for information-sharing and capacity-building by financial supervisory agencies throughout the world. The BIS also undertakes significant research related to various monetary and economic issues. These activities contribute in their unique and significant way to global financial stability.

5. With robust global growth and moderate inflation, international financial conditions have been benign over the past several years. These are good trends. However, financial stability cannot be taken for granted, and we need to take steps to ensure that there are no surprises on this front going forward. In this endeavour, all national jurisdictions, as well as the international institutions, have a role to play. Over the last few years, the BIS has extended its outreach by bringing together not only the developed market economies but also the emerging market economies in its discussions and initiatives.

6. Let me now focus on three aspects that I consider to be important in the context of maintaining financial stability at the national and global level:

i. ensuring effective cross-border cooperation to address the challenges from global banking;

ii. enhancing the strength and resilience of the financial system through fostering sound corporate governance practices; and

iii. continuing efforts towards greater interaction between accounting and prudential standard setters.

I will also briefly touch upon the challenges and the opportunities arising from the implementation of Basel II, and the need to remain focused on the long-term gains that will accrue while addressing the short-term challenges.

Global banking: challenges in a cross-border context

7. Globalisation has led to manifold increases in the cross-border activities of financial institutions. This has positive implications because it serves as a catalyst for domestic reforms, thus enhancing the long-term growth potential of the economy. It also makes the markets more competitive and the financial system more resilient. On the other hand, globalisation renders national financial systems more vulnerable to cross-border contagion as financial problems may be transmitted more easily across borders.

8. In a cross-border context, financial supervisors in the home and host jurisdictions of a global bank need to cooperate in various ways. These include ongoing monitoring of banks' operations under normal circumstances, as well as the management of problem bank situations. For normal prudential oversight, it is important that all cross-border establishments are effectively supervised on a consolidated basis. To ensure this, there is a need for clear mutual understanding of the roles and responsibilities of the home and host financial supervisors and for periodic sharing of relevant and timely information. This can be achieved through informal arrangements or through formal memoranda of understanding in a bilateral or a multilateral context. I understand that India has bilateral information-sharing arrangements with some supervisors and is participating in "colleges" of supervisors for effective Basel II implementation in a cross-border context. Such arrangements are currently being worked out by a number of jurisdictions.

9. In the case of a banking problem situation in a cross-border context, there may be a need for coordination not only between the home and host financial supervisors but also between home and host central banks, governments and other agencies. Further, there may be complexities arising out of the divergence in home and host country perceptions regarding both the systemic importance of the institution in question and whether liquidity facilities should be provided. In this context, there is a need for a definite framework for information-sharing and decision-making, as well as for managing conflicts of interest by putting in place cost-sharing and burden-sharing arrangements among jurisdictions. It may be desirable to have such enforceable arrangements ex ante, because once a problem situation develops it may spread so fast and so far as to make it too late to work out such details. I may mention here that the banking supervisory authorities, central banks and finance ministries of the European Union agreed last year on a memorandum of understanding on financial crises, and are also working on simulation exercises to test the arrangements proposed.1

10. Effective cross-border information-sharing and cooperation arrangements would help strengthen global financial stability. Not only would this facilitate awareness and understanding by various authorities of the significant issues relating to cross-border establishments, it would also help identify potential problems that could then be addressed effectively and in a timely manner.

Corporate governance and the financial system

11. Corporate governance encompasses the set of relationships among a corporate entity's management, board of directors, shareholders and other stakeholders. It provides the fundamental structure through which the objectives of an entity are set and the means of attaining those objectives and monitoring performance are determined. Corporate governance is relevant not only to an individual institution but also to public and private entities dealing with it, as well as supervisory authorities, central banks and governments. Sound governance generates positive externalities and provides the basis for a strong and stable financial system.

12. Internationally, greater emphasis is being placed on the role that corporate governance can play in promoting financial stability. It is considered as one of the key factors that determine the health of the financial system and its ability to survive economic shocks. We may all remember that many of the financial crises and problems seen in recent years in both the developed and emerging economies can be attributed, in no small way, to fundamental weaknesses in corporate governance such as excessive concentrations of risk, lending to connected parties, poor credit policies or inadequate management of risks.

13. It is also acknowledged that practices related to corporate governance vary across jurisdictions due to the different cultural, legal and institutional contexts. In some jurisdictions, the coexistence of public sector and private sector ownership of entities brings further complexities on account of the differences in their objectives. However, this is not to say that such differences should disrupt the authorities and distract them from implementing sound governance practices. There are some common elements that underlie sound corporate governance, such as fit and proper criteria, due diligence procedures, and the competence and quality of executives. These elements are relevant across all institutions and jurisdictions. In this context, the recent measures initiated by the Reserve Bank of India to ensure sound corporate governance in both the private sector and public sector banks will have a positive impact on the functioning of the Indian financial system.

14. Given the important financial intermediation role of banks, their sensitivity to potential difficulties arising from weak corporate governance, and the need to safeguard depositors' funds, the Basel Committee on Banking Supervision (Basel Committee) has issued guidance on corporate governance for banks.2This guidance will facilitate a move towards convergence of governance practices in the banking sector. There is also, however, a need for jurisdictions to look at corporate governance more broadly, so as to encompass other participants and stakeholders in the financial sector.

Interaction between prudential and accounting standard setters

15. Global banking and global financial reporting practices go hand in hand. Sound and internationally harmonised accounting standards are important for a well functioning and stable financial system: sound accounting standards provide integrity of financial disclosures; harmonised standards encourage a common understanding and interpretation of financial information. These elements make it possible for the markets to more effectively monitor the performance of financial entities.

16. Over the past few years, a lot has been accomplished in the area of harmonisation of accounting standards. A number of jurisdictions have adopted the international financial reporting standards (IFRS) and in a number of other jurisdictions, including India, the national accounting regimes are being aligned more closely to international accounting standards. This is encouraging because accounting information forms the basis of prudential assessments.

17. In addition to the ongoing work on harmonisation of accounting standards, there is also a need for greater interaction between accounting standard setters and prudential standard setters, at both national and international levels. This is essential for mutual appreciation and understanding of the approaches and objectives adopted by accountants and supervisors.3Accounting standard setters aim to present a "true and fair" view of the financial condition of a firm. On the other hand, prudential standard setters encourage "prudent" behaviour in supervised institutions. The former look more at the past to assess the present. The latter look at the past not only to assess the present but also to anticipate what could lie ahead.

18. It is important for overall financial stability that accounting and prudential standards are mutually consistent to the extent feasible. The Basel Committee, which is hosted by the BIS, is committed to working closely with the International Accounting Standards Board (IASB). In fact, I serve as a trustee on the International Accounting Standards Committee (IASC) Foundation, which oversees the governance of the International Accounting Standards Board. The Basel Committee is engaged in an ongoing dialogue with the IASB and audit firms, not only to understand the rationale for various accounting standards, but also to enable the IASB and audit firms to understand prudential concerns arising from accounting requirements. This interaction has been fruitful and beneficial for both parties. The IASB took note of various prudential concerns in reviewing and issuing the revised IAS 39 standard on the valuation of financial instruments last year. For its part, the Basel Committee has issued prudential guidance on various aspects of IAS 39, such as the use of the fair value option4 by banks, and the implementation of sound credit risk assessment practices.5This guidance is not intended to conflict with or replace the accounting standard setters' requirements, but to complement them. A close interaction for mutual understanding between accounting and prudential standard setters also needs to be encouraged at the national level.

Basel II implementation - short-term challenges and long-term gains

19. To ascertain the status of Basel II implementation in various jurisdictions, a survey was conducted by the Financial Stability Institute of the BIS in 2004. The survey was updated earlier this year. The update reveals that a total of 95 jurisdictions (the 13 member countries of the Basel Committee and 82 non-Committee jurisdictions) plan to adopt Basel II. However, the implementation time frames and the approaches adopted will vary across jurisdictions.

20. I understand that India has adopted a "three-track approach" for prescribing capital adequacy requirements for banks.6Commercial banks at present under Basel I will move to the simpler approaches of Basel II next year. Cooperative banks that currently maintain capital for credit risk under Basel I and surrogates for market risk, will continue to do so in the near term. Rural banks, at present subject only to prudential norms, but not to Basel I capital requirements, will continue on the same approach for some time. This segregated and gradual approach is an illustration of what the implementation of bank capital adequacy standards is all about. It is doing what is relevant and suitable to a country's individual circumstances.

21. This brings me to the issue of how ensuring the relevance and suitability of the timing and nature of implementation requires certain challenges to be addressed in the short term. I would like to mention specifically the need for: capacity-building at various levels in banks and supervisory authorities; improving the overall risk management culture in the financial sector; building up clean, comprehensive and robust databases; and putting in place strong and reliable IT systems for a smooth transition to Basel II. All jurisdictions will need to address these challenges, albeit to varying degrees.

22. I have already discussed cross-border issues with respect to global banking. Implementation of Basel II in a cross-border context also poses certain challenges because of the diversity of approaches and varying implementation dates in different jurisdictions. In order to conserve scarce financial supervisory resources, to ensure a level playing field for the banks operating in multiple jurisdictions and to minimise supervisory arbitrage, it is essential to ensure proper coordination and cooperation among home and host supervisors. Home-host cooperation arrangements need to be comprehensive and yet flexible in order to capture the specific cross-border challenges.

23. In the long term, Basel II implementation can make a significant contribution to financial stability. Two expected long-term gains are noteworthy. The first is the encouragement of, and the continuing improvement in, risk measurement and risk management practices in banks. This will also lead to closer alignment of regulatory capital with how banks calculate and manage their economic capital. Over time, this will contribute to improved bank risk profiles and a strengthened financial system.

24. The second significant long-term gain, which also presents a challenge in the short term, is that greater bilateral and multilateral interaction and communication between supervisors and banks will allow a better appreciation of the dynamics of national financial systems. This close interaction will also lead to improvements in the supervisory framework for evaluating and assessing risks. And finally, the increased interaction will facilitate the understanding of the need for continued efforts towards maintaining global financial stability.

Conclusion

25. Let me conclude by summarising the issues that I have talked about today. First, global banking will flourish in a strong and stable financial environment. Effective cross-border cooperation arrangements will provide strength and stability to financial systems nationally and globally. Second, adoption of sound corporate governance practices by all the entities in the financial system will improve the robustness of national and global financial systems. Third, accounting standard setters and prudential standard setters need to develop an understanding of each other's approaches. Their cooperation will result in a step forward towards maintaining financial stability.

26. I am happy to be at this conference. It provides an opportunity to be in touch with developments not only in the region but also in the broader global financial system. I wish the conference every success.

Thank you.


1 Memorandum of Understanding on Co-operation between Banking Supervisors, Central Banks and Finance Ministries of the European Union in Financial Crisis Situations, European Central Bank, press release, May 2005.

2 Enhancing corporate governance for banking organisations, Basel Committee on Banking Supervision, Bank for International Settlements, February 2006.

3 Accounting, prudential regulation and financial stability: elements of a synthesis, Claudio Borio and Kostas Tsatsaronis, Bank for International Settlements, September 2005.

4 Supervisory guidance on the use of the fair value option for financial instruments by banks, Basel Committee on Banking Supervision, Bank for International Settlements, June 2006.

5 Sound credit risk assessment and valuation for loans, Basel Committee on Banking Supervision, Bank for International Settlements, June 2006.

6 Reforming India's financial sector - changing dimensions and emerging issues, speech by Dr Y V Reddy, Governor, Reserve Bank of India, at the International Centre for Monetary and Banking Studies, Geneva, May 2006.