Financial reforms: what are the common lessons for prudential supervisors?

Speech given by Mr Jaime Caruana, General Manager of the BIS, at the IAIS Annual Conference on “Insurance as a means of socio economic development: financial crisis and the future of insurance markets”, Rio de Janeiro, 22 October 2009.

Abstract

Three key lessons from the global financial crisis are important for both banking and insurance supervisors. First, we need to broaden our focus from the supervision of individual institutions to taking into account system-wide risks. Second, we have to deal with the procyclicality inherent in the financial system. Third, better regulation is not enough if not implemented as intended and in a consistent manner across countries. These three lessons should serve as important signposts for all prudential supervisors, and I am confident that the IAIS will help us to meet these challenges. The BIS and other Basel-based bodies will continue to fully support the IAIS in this endeavour. We have a complex financial system where old boundaries between sectors no longer apply. This puts a premium on closer cooperation among standard setters, supervisors and policymakers.

Full speech

It is a great pleasure for me to address today such a distinguished audience of high-level insurance regulators and supervisors as well as representatives of the worldwide insurance industry. Thank you for inviting me to discuss with you some key lessons of the financial crisis from a BIS perspective that can be of interest for all financial supervisors. We all face important common challenges, even if we must recognise that business models differ across sectors.

Towards a safer destination

The crisis has triggered significant reforms and a number of important debates that will have long-lasting implications. Today I would like to share with you some thoughts on certain aspects of ongoing regulatory reforms. Many efforts are under way in various areas, and much has already been achieved. Allow me to give a few examples. The monitoring of financial markets is being enhanced through the conduct of Early Warning Exercises led by the IMF and the Financial Stability Board (FSB). In early September, the supervisors and central bank Governors of 27 major industrial and emerging economies adopted a comprehensive set of measures to strengthen regulation and supervision of, and risk management in, the banking sector. And today’s conference clearly shows that significant progress is being made in the regulation of the insurance industry.

I will not review all these efforts in detail. The recent reports by the G20, the FSB and various standard setters provide a clear and comprehensive view of what has already been achieved. My main message is that we are facing complex issues and more work is needed to find well balanced solutions.

Let me start with some thoughts about the future and the changes and reforms that are needed. In 2017, 10 years after the beginning of the current crisis, OECD countries will have an average ratio of gross public debt to GDP that will exceed the 2007 level by 30 full percentage points. In some of these countries, this ratio is projected to at least double over the same period. These projections are not based on extreme, stressed scenarios, but on the expectation that these economies will recover and that fiscal consolidation measures will be adopted. In fact, the deterioration in fiscal positions could be much more severe in case of adverse developments. These fiscal figures highlight the magnitude of the policy actions that have been required to address the recent crisis, and therefore the absolute need for changes and reforms looking forward.

The last few months have witnessed improved conditions across a number of financial markets and better than expected macroeconomic news. But some financial markets are still not working properly after their recent unprecedented failure. The message from policymakers is clear: we must sustain the reform impetus and not return to the previous status quo. An enhanced financial regulatory framework will allow for a safer and sounder financial system which is less prone to the kind of leverage (both off- and on-balance sheet) and excessive risk-taking we observed before the crisis. We at the BIS have emphasised that the road to this new, safer destination is narrow, meaning that there are significant risks. Important adjustments and reforms in the real economy will be required. Some features of the business models of financial institutions will have to change. Maintaining the momentum for financial stability reforms, and in particular establishing clear objectives and timetables, is thus critical.

Most debates focus on regulatory reform. But let me emphasise that better regulation alone will not be enough. First, we need a better, structured collective monitoring of how vulnerabilities develop in the financial system and the commitment to address these fragilities. In the official sector, this is what the Early Warning Exercises and the newly established FSB Standing Committee on Assessing Vulnerabilities are all about. A second key area for improvement is better integration of financial stability objectives into our macroeconomic policy frameworks to make sure that they help lean against the build-up of financial excesses in the first place. Third, we must strengthen financial market infrastructure, for instance by promoting trading through central counterparties. Fourth, and perhaps most importantly, implementation is essential.

So, various elements are necessary to ensure a safer financial system. Nevertheless, better regulation is obviously an important part of the solution, and I will now discuss this particular aspect. My view is that the global financial crisis has revealed common lessons for all prudential supervisors, and in particular for banking supervisors and insurance supervisors. Allow me to focus on three key lessons:

  1. The need for a system-wide view of risk: we must connect the dots.
  2. The need to deal with procyclicality while maintaining adequate risk sensitivity: we must push back against the natural tendency of market participants to understate risk in good times.
  3. The need for consistent implementation of regulation: we must not just adopt the right rules, but make them stick.

First lesson – The need for a system-wide view of risk

The global financial crisis has taught us that we need to broaden the focus of prudential supervision, focusing less on single entities and more on how the components of the financial system interact. Our understanding of these interactions proved limited when the crisis occurred – we failed to connect the dots. Because of such interactions, system-wide risk can be much larger than the sum of the risks posed by individual institutions. We must develop a system-wide view of financial risks.

This is referred to as the “cross-sectional” dimension of the macroprudential approach to regulation. This dimension relates to how risk is distributed within the financial system at a given point in time.

Recent developments have highlighted the importance of this cross-sectional dimension: the way systemic risk materialised in the banking sector was without precedent. A “traditional” banking crisis was thought to mainly emerge through a loss of confidence leading to a “run” by retail depositors. In contrast, an unexpected feature of the crisis that started in 2007 was that interbank and wholesale funding markets ceased to operate properly due to a lack of confidence in counterparties. We must understand better how asset deflation, forced selling, leverage, counterparty risk and the real economy interact, reinforcing adverse dynamics.

Prudential tools should be calibrated so as to take into consideration the contribution of individual institutions to system-wide risk, for instance by requiring tighter prudential supervision that could include asking for a “systemic capital charge”. Making this concept operational is not easy: how should we measure system-wide risk and assess the contribution of a single institution to it?

The latest issue of the BIS Quarterly Review, published in September, presents some work that may prove useful in thinking about these issues.1 First, there is a potential trade-off between diversification at the level of individual institutions and at the level of the system. By diversifying its portfolio, and hence reducing its own riskiness, an institution could become more similar to others, increasing overall systemic risk. Second, the contribution to systemic risk increases more than proportionately with relative size. Third, for a target level of system-wide risk, capital can be used more “efficiently”, as the increase in the capital of those institutions contributing the most to system-wide risk can be more than compensated for by the reduction that occurs in the smaller ones.

In this context, and in response to a request from the G20, the IMF, the FSB and the BIS have been developing high-level guidelines so that national authorities can better assess the systemic importance of financial institutions, markets and instruments. In a nutshell, it is recommended that the following criteria be considered to identify the systemic importance of an individual component of the financial system: size, ie the volume of financial services the institution provides; substitutability, ie the extent to which the same services can be provided by other components of the system in the event of a failure; and interconnectedness, ie the linkages existing with the other components of the system.

These criteria can help in assessing what systemic importance entails. The capacity of the institutional framework to deal with financial failure is also a key element. In particular, there must be a process to organise the orderly winding-down of financial institutions which are relevant system-wide so that they cannot be considered as “too big too fail”. This will not only lower systemic risk, but will also reduce moral hazard.

I will not discuss in detail to this audience how insurers can pose a systemic risk. Insurance business models are very different from those of the banking sector, and indeed can contribute positively to financial stability. In particular, insurers with a long-term time horizon can help stabilise markets. Life insurers aggregate the long-term savings of individuals, which are then invested in the real economy, supporting stability and capital formation in the economy. Insurers also provide a mechanism for the transfer and pooling of risks into more predictable aggregated exposures. This can enhance the management of risks and reduce overall financial system-wide risk.

However, I would caution against being too confident. The combination of asset deflation, protracted low interest rates, inadequate capital quality of firms and insufficient market and funding liquidity could lead to adverse dynamics. Efforts by the IAIS to better understand how, and to what extent, insurers can be a source of systemic risk must be sustained. In particular, it is essential to develop tools to measure systemic risk that take into consideration the peculiarities of the insurance sector.

It is also vital to understand how insurers can be interconnected with other parts of the financial system, thereby amplifying system-wide risk. The fact that the IAIS is an active member of the FSB will surely help enhance our common understanding of such cross-sectoral interconnections.

Let me conclude my comments on the first lesson for supervisors by underlining a prerequisite. Before we can adequately understand system-wide risks we need to understand group-wide risks. The global financial crisis has shown that this was not the case in the past. In the banking industry, off-balance sheet risks were not well understood. In the insurance industry, the failure of AIG demonstrated that group-wide risk can be driven by a specific, risky business entity. While it is true that the risk emanated from the part of AIG that was outside the purview of insurance supervisors, that should not be of great comfort.

Gaps in regulation need to be closed to ensure that prudential supervisors can assess the risks of a group on a consolidated basis. The Joint Forum is already working on the differentiated nature and scope of regulation that will help identify problematic differences and gaps across sectors. Turning to supervision, one must proactively look through structures, subsidiaries, special purpose vehicles, etc – a task which will require coordinated efforts by supervisors across sectors and jurisdictions. Good accounting and prudential frameworks are also needed for effective supervision of complex groups. The bottom line is that authorities must collectively work to remove impediments to effective group supervision rather than use them as a reason for inaction.

Second lesson – The need to deal with procyclicality

The second key lesson of the crisis for prudential supervisors is the need to deal with procyclicality. This represents the second, or “time”, dimension of the macroprudential approach to regulation, which relates to how system-wide risk evolves over time. This dimension reflects the natural tendency of the financial system to amplify business cycles. System-wide risk can be amplified over time through interactions within the financial system as well as feedback between the financial system and the real economy. Credit extension and leverage, risk perceptions and risk appetite, asset prices and economic activity, all reinforce each other over time with complex, non-linear dynamics. Individuals and firms become overextended in good times, with excessive retrenchment in bad times.

The guiding policy principle must be to build countercyclical capital buffers in good times, when it is easier to do so and can help to restrain risk-taking. In bad times, running down the buffers allows the system to absorb emerging strains more easily, dampening the amplifying mechanisms.

In the banking sector, the Basel Committee on Banking Supervision has been working to translate this policy principle into a concrete proposal that will enhance the existing Basel II framework. Similarly, there is certainly room for the community of insurance supervisors to reflect on how procyclicality effects can arise in the insurance sector and how they can be mitigated. Of course, addressing procyclicality – while maintaining adequate risk sensitivity – is a complex task, and concrete proposals are difficult to design properly. Moreover, these issues are likely to differ significantly between the insurance and the banking sectors, not least because of differences in the respective business models.

Nevertheless, the ongoing work of the Basel Committee has revealed some lessons that can be of interest for insurance supervisors too. One is that it is difficult to find the kind of indicators that can be used for guiding both the build-up of buffers in good times and the release of capital in bad times. The solution is to be pragmatic and cross-check a number of variables, acknowledging that relying on a set of imperfect indicators is better than considering none at all. There are also some principles that have been agreed by the banking supervision community that can be useful for other supervisors, such as the preservation of capital principle: the fact that earnings should not be fully distributed through dividends and payments as long as the capital basis of the firm has not been restored. Another lesson is that the quality of capital matters. The crisis has shown that in times of stress the best-quality capital is in demand, and that markets can overreact if a financial institution is seen as relying excessively on non-core capital.

Third lesson – The need for consistent implementation of regulation

Globalised financial markets and level playing field considerations require an appropriate internationally agreed regulatory framework to be in place. So far, I have limited my comments to how to enhance this regulatory framework. However, implementation matters too. My third key lesson relates to the application of international standards.

The recent crisis has highlighted that many problems derived from the inadequate application of similar prudential regulation rather than inherent weaknesses in regulatory requirements. Indeed, good supervision appears to have played an important role in insulating banks in countries such as Australia and Canada from the global financial turmoil, suggesting that proper, proactive enforcement of regulation at the national level is essential, and that sufficient resources should be devoted to this task. Even sound regulatory frameworks can be undermined by poor implementation and enforcement of the rules.

The implementation of regulation must also be consistent across jurisdictions, and requires full cooperation among national authorities. Severe financial crises of the magnitude of the current one tend to reinforce national bias in policy actions. To some extent, this can be explained by local specificities and the pressures to react rapidly to financial stress. But if this kind of nationalistic orientation goes too far and becomes entrenched, it can hamper cross-border finance, undo some of the benefits of many years of globalisation, impede a level playing field and economic efficiency, and reduce global growth and well-being. So we need both international standards and strong supervision cooperation to properly support national frameworks.

The G20 is playing a key role in achieving such coordination. It has provided strong political impetus for international cooperation, with a clear commitment by G20 members to implement international agreements and standards. This is particularly important because we are dealing with new and complex financial reforms.

The IAIS is also playing an important part in facilitating the establishment of sound insurance regulatory and supervisory systems, especially in emerging markets. This work must continue. I am happy to note that a key milestone is being reached during this IAIS Annual Conference with the launch of insurance content on FSI Connect, the online learning tool and information resource developed by the Financial Stability Institute of the BIS for financial sector supervisors. Just five years after its launch in mid-2004, the reach of FSI Connect is impressive – 8,000 individuals from over 200 organisations and 140 countries around the world access its tutorials regularly. So far, FSI Connect had focused primarily on matters of interest to banking supervisors, and the new initiative launched today will help close the gap with insurance supervisors. You will hear more about the new insurance tutorials later this afternoon, and I would also encourage you to visit the FSI Connect booth during this conference.

Conclusion

Let me conclude. Three key lessons from the global financial crisis are important for both banking and insurance supervisors. First, we need to broaden our focus from the supervision of individual institutions to taking into account system-wide risks. Second, we have to deal with the procyclicality inherent in the financial system. Third, better regulation is not enough if not implemented as intended and in a consistent manner across countries. These three lessons should serve as important signposts for all prudential supervisors, and I am confident that the IAIS will help us to meet these challenges. The BIS and other Basel-based bodies will continue to fully support the IAIS in this endeavour. We have a complex financial system where old boundaries between sectors no longer apply. This puts a premium on closer cooperation among standard setters, supervisors and policymakers.

Thank you for your attention.


N Tarashev, C Borio and K Tsatsaronis, “The systemic importance of financial institutions”, BIS Quarterly Review, September 2009.