Regulatory-Risk

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Regulation cannot be avoided by banks

Filed Under: Regulation, Supervision

Plain and simple, banks are important because they introduce efficiencies to the local as well as the global economy.  Regulation and supervision of conduct has become an important component of doing business as a bank.

Reasons why banks are important

There are 3 reasons why banks are important to society.

  1. Banks act as intermediaries through which surplus funds can be made available to finance productive activities in the economy.
  2. Banks offer a range of needed financial services to the public such as payment services and the storage of wealth for safekeeping.
  3. Banks are also able to increase the supply of money through credit extension.

All three of these reasons create efficiencies in the economy. It’s therefore in societies interest that somebody ensures that these efficiencies are not diminished and stay in place to help society. Effective regulation can play a role in achieving this aim.

Why banks must submit to regulation

As an example, the efficiencies that are created by banks in the economic system enable monetary authorities to reach better decisions that will affect all of us. The efficiencies banks create therefore become a ‘public good’ because everyone benefits from better monetary policy decisions. Efficiencies become a public good because they do not reduce in availability as benefits are derived by society, nor is it possible for anyone to be excluded from deriving the benefit. Regulation can make sure that these efficiencies are protected so that society can continue to derive benefits from the efficiencies created.

A more practical reason banks should be subjected to regulation relates to the unique nature of the business of a bank.  Taking a simple approach to the business model of a bank, it can be reduced to the taking of deposits and the lending of these deposits to other parties at a profit.  The liabilities of a bank or its deposits are generally short-term in nature and certain in amount. The public makes a deposit and withdraws it when needed and banks repay these deposits when they are required to do so.  Banks know with relative certainty the amount they must at some future date repay to depositors. On the other hand, the assets of a bank or the loans that it makes, are generally long-term in nature and uncertain in value.  The assets are uncertain in value because a bank can never be certain that the loan it grants will be paid in full over the specified period.

A banks business is therefore inherently risky, and poor loan decisions can result in the loss of depositors funds causing the failure of a bank when it is unable to repay its depositors. Ensuing loss of confidence in the banking system by the public will impact upon all the efficiencies enumerated above.  The recent financial crisis has shown that this loss of confidence in the banking system brought into being by either bank failure or the treat of bank failure, has a high cost on society.  This cost far exceeds the cost of intervention through regulation when saving systemically important financial institutions. Intervention to save banks when they are in financial trouble, is a compelling reason banks should be subject to stringent regulation and that they are prudently managed by competent, experienced and ethical people.

Another reason banks should be regulated is because depositors do not have enough information about the true risks that a bank is exposed to.  Depositors earn interest from the bank for the funds they place with them. The interest rate they receive is proportional to the extent of the risk their funds are exposed to. The higher the risk, the higher the interest rate they would expect to receive. Interest rates are therefore a good indicator of the extent of risk the deposit is exposed to. This information should be communicated transparently by banks and not be masked by keeping deposit interest rates low to boost their margins.  Depositors have a right to know how their funds are being applied so that if they are not comfortable with the risk exposure, they may move their finds to a less risky investment.  Regulation is an ideal mechanism to set minimum standards of disclosure to the public and in this way make sure that relevant information is communicated and not withheld from the public.

What is regulation and supervision about?

Regulation is about the creation and maintenance of a legal framework within which a bank is licensed to operate.  Banks become subject to prudential rules and practises through regulation once they are licensed to receive deposits from the public.

Supervision on the other hand is about the process of monitoring the control systems, activities and financial condition of banks to make sure that they are within the limits of prudent banking practise that are set out in the legal framework established by regulation.

Objectives of regulation and supervision

There are three main objectives.

  1. Ensuring systemic stability
  2. Enhancing efficiency
  3. Investor and depositor protection

There is a tight interrelationship between these objectives and for this reason the same authority should perform both regulation and supervision.

Because banks play a pivotal role in the economy and monetary system and due to the risk of banks causing systemic failure, the most obvious candidate for this role of regulation and supervision is a central bank.  This role can be enhanced if a central bank is legislated as independent from the state.  This arrangement affords central banks the right under the law to act independently from the state facilitating independent regulation without political influence.  Many jurisdictions have adopted this model for their central banks such as Switzerland, United Kingdom, United States, South Africa, Australia and others.

Regulation and the regulatory landscape has shifted toward being composed of two main dimensions namely micro and macro-prudential regulation. Micro-prudential regulation focuses on oversight of individual financial institutions while macro-prudential regulation attempts to address systemic risks.

Clearly the goal of maintaining “safe and sound” institutions individually does not guarantee overall financial stability and central banks are well positioned to take account of this in their existing framework. Enhanced oversight of the financial system by central banks should not overburden it through excessive regulation, but rather facilitate the consolidation of financial regulation.

Systemic risk in financial markets

Filed Under: Regulation, Risk management

Introduction

The International Monetary Fund (“IMF”) has summarised the causes of the global financial crisis in three dimensions:

  1. Flaws in financial “regulation” and “supervision”.
  2. Failure of monetary “policy” to address the build-up of systemic risk.
  3. Weak global “financial architecture”.

Set out below is an analysis of these dimensions and a review of systemic risk, including what steps Regulators can take to mitigate the effect of systemic risk.

1.  Flaws in financial regulation and supervision

What has become known as the “shadow banking system” became larger as it was wedged in among lightly regulated financial services businesses such as Investment Banks and Mortgage Originators. At the time traditional financial services businesses were lightly regulated by a disjointed assortment of regulators. The process of deregulating financial markets had begun in ernest during the 1980’s and steadfastly increased in pace as prosperity and the good times seemed to be here to stay.

By 2008, it was estimate that in the United States the shadow banking system was as large as USD 10.5 trillion. It was made up of USD 4 trillion in assets from large investment banks, USD 2.5 trillion in overnight repos, USD 2.2 trillion in structured investment vehicles, and another USD 1.8 trillion in hedge fund assets. This should be compared with the USD 10 trillion in assets held in the conventional United States banking system.

Regulators were focused on individual institutions, without regard for the impact on the wider financial system. There is therefore a realisation by supervisors today that a macro-prudential approach to the supervision of financial markets is necessary.

2.  Failure of monetary policy to address the build-up of systemic risk

The latest IMF analysis points to “macroeconomic policies, which did not take into account rising systemic risks and states that a key failure during the boom period was the inability to spot the big picture threat of a growing asset price bubble” (IMF, 2009b).

Clearly, the U.S. Federal Reserve underestimated the build-up of financial imbalances coming from housing price bubbles, high leverage of financial institutions, and interconnections between financial markets. In addition, Taylor (2009) argues that the Federal Reserve policies brought excessive liquidity and low interest rates to the U.S. and that the federal funds rate was kept too low for too long, fuelling the housing boom and other economic imbalances. The Federal Reserve may well have assumed that, even if the asset price boom collapsed, the impacts on the financial system and the economy could be mitigated by lower interest rates.

In theory, tighter prudential regulation could have been mobilised to contain systemic risk; but in practice, before the authorities realised, huge systemic risks had accumulated below the regulators’ radar in the shadow banking system.

Given the failure of prudential supervisory action to prevent a build-up of systemic risk, the central bank — as a macro-supervisor — should have reacted to credit booms, rising leverage, sharp asset price increases, and the build-up of systemic vulnerabilities by adopting tighter monetary policy.

3.  Weak global financial architecture

There were also deficiencies in the global financial architecture the official structure that facilitates global financial stability and the smooth flow of goods, services, and capital across countries. There are three issues.

First, global institutions like the IMF, the Bank for International Settlements, and the Financial Stability Forum failed to conduct effective macroeconomic and financial surveillance of systemically important economies. That is, they did not clearly identify the emerging systemic risk in the U.S., the U.K., and the euro area; send clear warnings to policymakers; or provide practical policy advice on concrete measures to reduce the systemic risk. Their analysis clearly underestimated the looming risk in the shadow banking system; interconnections across financial institutions, markets, and countries; and global macroeconomic-financial links.

There was considerable discussion of global payments imbalances during 2002–2007. The IMF in particular warned repeatedly, especially through the newly established multilateral consultation process, that global imbalances posed a serious risk to global financial stability. However, the global imbalance discussion may have diverted policymakers’ attention away from U.S. domestic financial imbalances, the risk of U.S. dollar collapse, and the need to revalue the Chinese currency.

The crisis has revealed the ineffectiveness of fragmented international arrangements for the regulation, supervision, and resolution of internationally active financial institutions. The problem became particularly acute when such institutions showed signs of failing. Although home-country authorities are mainly responsible for resolving insolvent institutions, host-country authorities were often quick to ring-fence assets in their jurisdictions because of the absence of clear international rules governing burden-sharing mechanisms for losses due to failure of financial firms with cross-border operations.

Addressing systemic risk

The purpose of macro and micro-prudential supervision is to preserve financial stability by identifying vulnerabilities in a financial system and calling for policy and regulatory actions to address those vulnerabilities in a timely and informed manner so as to prevent systemic risk and crisis.

What are micro and macro-prudential regulation?

  1. Micro-prudential supervision takes a bottom-up approach to analysis and preservation of systemic financial stability, focusing on the health and stability of individual institutions.
  2. Macro-prudential supervision takes a top-down approach to analysis of systemic risk with a focus on the economy-wide system in which financial institutions operate. This approach aids in the identification of risks and perverted incentives that could result in systemic instability. It requires the integration of detailed information on banks, non-bank financial institutions, corporations, households, and markets.

Taking into account the different approached of micro and macro-prudential regulation, what actual steps can be taken by Regulators.

Competition regulation

  1. Limits on the “too big to fail” or “too interconnected to fail” problem
  2. Market conduct regulation
  3. Enhanced transparency and competition Macro-prudential measures
  4. Higher standards on capital requirements and risk management for systemically important firms
  5. Limits on financial firms’ leverage, such as setting maximum leverage ratios and/or credit growth
  6. Efforts to mitigate procyclicality with automatic countercyclical provisioning, such as a form of dynamic provisioning
  7. Limits on sectoral exposure

Households

  1. Loan-to-value (LTV) restrictions for mortgages
  2. Limits on consumer debt, such as debt-to-income ratios

Corporations

  1. Limits on leverage, such as limits on debt/equity ratios
  2. Limits on tax advantages, such as disallowing interest deductibility for leverage exceeding a certain level or foreign currency-denominated loans External
  3. Limits on external debt
  4. Limits on currency and maturity mismatches