Supervision | Regulatory-Risk

Central Banks and Supervision

There are proponents and opponents of centralising the regulation of the financial system, with some arguing that it should be managed by Central Banks.

Regardless of your stance on the matter, the crux of the debate lies not in whether centralisation of regulation should occur, but rather when and how central banks should assume these responsibilities.

During the 2008 financial market crisis, swift and decisive action was required from many regulators, including central banks. Their role was to stabilise the financial system and prevent the collapse of banks and other systemic financial institutions. However, the coordination of the efforts of various regulators, particularly central banks, who were not the main regulatory bodies in many jurisdictions, was lacking.

Regulators responsible for different market segments struggled to coordinate their efforts, sometimes acting unilaterally against each other. This highlighted the need for swift, coordinated action from regulators when institutions and financial markets collapse. Central Banks are ideally positioned to assume this role of central command and control.

From the start of the crisis, regulators were caught off guard by the inter-connectivity between banks and financial institutions. While they believed globalisation of financial markets had occurred, they lacked understanding of the interconnectedness between market players like banks and non-bank financial institutions. This lack of awareness led to a perception that matters could spiral out of control rapidly due to this inter-connectivity.

Operating in a globally inter-connected market raises issues around the concept of lender-of-last-resort. In particular, which regulator in what regulatory jurisdiction should take on the final regulatory responsibility for intervention to save institutions when the financial system fails, whether they be banks or non-banks.

Consider that a regulator solely responsible for the efficient operation of banks may not fully comprehend or consider how their decision to save specific banks from failure could impact other areas of the financial system. Accounting for the interconnectedness of the financial system, a failure could originate from any point and be caused by the actions of various players, including banks, insurance firms, and asset managers. In each case, these players are often regulated by different regulators, with central banks playing a limited role in day-to-day regulation.

During the financial market crisis of 2008, it is clear that the State in various jurisdictions took responsibility for stabilising failure in their own financial system. But, while they may fulfil the lender-of-last-resort role, they are often not the actual market regulator.

In extreme market stress conditions, the State will normally take on the role of lender-of-last-resort. It is never some arbitrarily independent regulatory body like the FSA (abolished in 2013) in the United Kingdom or APRA in Australia who fills this role. Independent regulatory bodies simply do not have the financial resources available compared to Central Banks.

As the banker to the State, Central Banks have access to resources that independent regulatory bodies do not. Independent regulators must, in circumstances of market failure, approach Central Banks directly anyway for help because they control these financial resources as the bankers to the State and not the independent regulator.

The inherent problem in existing arrangements is the delay in response to market failures. This is because Central Banks, being detached from the day-to-day supervision of markets by independent regulators, often need to be convinced of the necessity to intervene before they can take action. This process of persuasion can lead to further delays, potentially exacerbating the problem. The image of the Roman Emperor Nero playing his fiddle while Rome burns serves as a poignant reminder of the consequences of inaction.

It follows that because it is the State that ultimately carries accountability for stemming failure in the financial system, that it must be their banker or Central Banks that carry out the duty of lender-of-last-resort on behalf of the State.

Due to this duty, it is clearly necessary for Central Banks to stay close to all activities conducted in the financial system. Therefore, there is a strong case for Central Banks to be involved and regulate key financial market activity. Central banks are also ideally positioned to serve as a coordination point for regulating the diverse modern financial market.

Policy setters are aware of the relationship between the State, Central Banks, and the financial market. They will undoubtedly consider this relationship when establishing any regulatory system following the 2008 financial market crisis.

Warning signs not enough for Regulators

Filed Under: Financial Crisis, Supervision

Warning signs like the failure of Enron, Arthur Andersen and others that occurred during and after the dot.com boom in the late 1990’s, were not internalised by banks or the financial market. Regulators took steps to prevent these conditions from arising again but these measures were not effective enough.

In general, regulators took several key steps. They included the introduction of Sarbanes-Oxley in the USA. There was also an enforced improvement of global risk management standards and tools. Additionally, the Basel II capital requirements were revised.

The world adopted a belief in beefed up Financial Regulators. They would act as the ‘new’ watchdogs. These watchdogs would ensure that the financial community stayed within acceptable bounds. This created the impression that the twenty-first Century would be the golden hour. Regulation and risk management had advanced significantly. Most believed that the risks banks were exposed to had become known. They also believed these risks were manageable, and being managed.

There were warning signs but they were ignored

The exuberant confidence in risk management did not work out as planned. When in 2006 the warning signs became impossible to ignore, it was essentially to late.

The markets unraveled. Participants began to believe that the collapse of the USA sub-prime mortgage market caused the financial markets crisis. It was certainly part of the problem but not as important as many believe.

Far more important is the evidence that banks had leverage ratios of between 30 and 40 times their capital. These borrowings were used to support assets on their balance sheets that they believed would continue to increase in value. These assets were held,

either directly by the banks on their balance sheet carrying regulatory capital against the risk exposure, or
through arrangement off-balance sheet through special purpose vehicles that were set up specifically for securitisation purposes. While the assets were off-balance sheet, the risk and exposure never was.

Securitisation’s employed by banks removed the assets from their balance sheet and housed it outside the regulatory ambit of regulators. Banks assumed the risk of default on the asset would transfer to the special purpose vehicle. Therefore, they did not need to hold regulatory capital against the risk. This meant that once the assets was securitised the regulatory capital was freed to be used once more. This scheme enabled banks to take on more and more dubious loans. It became like a conveyer belt. Assets moved on and then off the banks balance sheet continually. The same amount of capital was made available each time but the risk remained mostly with the bank. Risks were building up in banks without an increase in levels of capital to match the increase in risk.

Banks and regulators seemed to be surprised when these assets began to decrease in value due to high default levels. This is not withstanding banks own lax credit risk standards being applied when granting the loans, which were sanctioned by regulators during their oversight of banks. Therefore, to understand the cause of the increase in defaults you need only to look at the credit risk policies in these banks. Today no bank would grant a loan to a client who had No Income, No Job or Assets (NINJA) but this was common credit risk management policy in banks before the financial crises. Banks held the mistaken belief that credit risk was not a problem anymore and that anyone could have a loan. Modern risk mitigation tools such as securitisation had superceded credit risk entirely and this was believed by both the banks and regulators.

It seemed to escape banks especially that the application of very poor credit risk management policies at the point of granting the loans was the underlying cause of the market failure. Confidence eventually began to erode in banks ability to absorb the losses arising from these loans whether they were housed on or off-balance sheet. As calls were made by lenders for the repayment of their loans that banks had used to acquire these now questionable assets, banks found when trying to realised these on or off-balance sheet assets that the value had just evaporated.

Bankers and regulators had forgotten or chosen to ignore fundamental risk principles, this was done on the premise that advanced models and risk management tools were effective and that the financial market had become self-regulating. They were wrong in their view and shocked when the financial system on which world economies are built upon, broke down.

Paul Moore, the former head of Group Regulatory Risk at HBOS said of the financial crisis that it felt like they were in a rowing boat trying to stop a tanker, when they should have been the pilot employed to steer the boat through a challenging course. Professional risk management is all about doing the right thing for the right reason, it should never become an ineffective tick the box exercise.

Laws and regulations are by their very nature generic and only define the minimum standards that are required to be implemented by banks and monitored by regulators. One of the most important roles of the regulatory risk management function in banks is to maximise opportunity for banks that within a strict regulatory framework, while minimising any potential downside that banks could be exposed to within this regulatory framework. In circumstances where it is an imperative to stop certain activity or practise in banks because of risk, authority should centre in an approved risk management framework. This means that for risk management to be effective this framework must include the conduct of every employee, the banks culture toward risk appetite and the ability for risk managers to voice concerns in statutory forums such as board meetings grounded on feedback from business.

The ISO 31000 risk management standard released earlier in 2009 proposes principles that should be adhered to if an organisations risk management is to be effective. These principles include among others, the following:

Create value
Be an integral part of organisational processes
Be part of decision-making
Be systematic, structured and timely
Be tailored to the context
Be dynamic and responsive to change

The regulation of financial markets has changed, whether one examines it from a self-regulating perspective i.e. the ISO 31000 standard or by increased regulatory vigilance and intensity applied by regulators across all markets. For risk management to be effective, risk managers should have a clear mandate and authority from both the board of banks and regulators and operate within an agreed proactive risk management framework. Unless risk managers have authority to do more than tick boxes and report after the fact, risk management practise will always be superseded by the principle of profit maximisation.

Regulators were surprised, what’s the policy?

The factors that took regulators by surprise during the recent financial crisis brings into focus some insightful indicators of potential future regulatory policy. This can be inferred simply because regulators do not like being caught by surprise. Regulators will put measures into place to avoid surprises if banks prove that they are unable to manage themselves or the risks that they are exposed to. The measures that regulators bring to financial markets originate in the promulgation of legislation.

Legislation has a significant long-term impact on markets and while not taken lightly by regulators, it is their main policy tool used to effect change. Regulators have always been guided in their policy by the activity conducted within financial markets and have been reactive to changes in market conditions and not proactive. A paradigm shift has occurred as regulators globally have become more proactive in their approach to the application of regulations. We will therefore increasingly see proactive engagement from regulators and less tolerance to any deviation by banks in what they consider to be acceptable risk management practices.

So, what were these surprises?

Regulators were surprised by the speed at which banks were drawn into the financial crisis and how quickly it spread so severely to all parts of the globe. This phenomenon reinforces linkages and the global nature of business, which introduces fragility to the market that must be catered for in future.
The role of securitisation as a risk mitigation tool was underestimated. It is unlikely that financially engineered products will be embraced again to the same extent in the near future.
The weakness of capital buffers. The data used in models to determine capital buffers was insufficient therefore the predicted capital requirements were inaccurate.

Accordingly, the expected changes to the regulatory environment could include some or all the following changes.

Internal risk rating methods used to asses counterpart risk by banks, supported by market credit rating agencies will be overhauled. The Basil capital accord will in future accommodate this and allow banks some discretion on the methods employed.
Securitisations will be monitored more closely and evidence offered up to regulators that all the associated risks are being managed effectively.
Regulators will require that increased prescribed capital and liquidity buffers be built up during the ‘good times’ so as to have better cushions in the ‘bad times’. This is common sense practise but it will have significant implications to the cost of capital for banks.
Risk management will have to become more transparent. Regulators will require that all products marketed by banks undergo a rigorous risk analysis before they are offered to the market or public.
Increased public disclosure and peer review processes may be prescribed by regulators and implemented by banks. Banks are custodians of public funds and it is the public that regulators believe have a right to know when their money is being placed at increased risk.

Ok, so what can we conclude from this?

Banks work within a global financial system and can choose where to conduct business and so choose how severely they are regulated. Not all jurisdictions have regulatory equivalence or apply the same standards of supervision over banks. This is however changing as regulators respond to the financial crisis and address regulatory deficiencies across jurisdictions. Banks as well, should take into account where they are registered and supervised because they should never be seen to practise regulatory arbitrage as it may damage their reputation and public confidence. Being free of regulation today may not go down well with their customers tomorrow. Depositors need their banks to be well-managed and protected by effective regulation.

There are increasing signs that common global regulatory practises are being adopted in jurisdictions that were previously lax. This is a positive development for financial market stability. Care should be taken though to make sure regulatory practise does not become so harsh that banks are unable to develop creative solutions for which they have become renowned.

Today the public consensus is that banks as custodians of public wealth have an obligation toward society to protect this wealth so entrusted to them. Regulators have a duty to make sure that banks uphold and respect this principle of trust and so impose themselves firmly on the financial market system when this principle has been ignored by banks. This focused regulatory oversight by regulators is happening and it will not change in the foreseeable future regardless of what jurisdiction banks decide to hang their hat in, regulation will be there.

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.

Banks act as intermediaries through which surplus funds can be made available to finance productive activities in the economy.
Banks offer a range of needed financial services to the public such as payment services and the storage of wealth for safekeeping.
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.

Ensuring systemic stability
Enhancing efficiency
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.

Basel III a reality

Filed Under: Basel, Supervision

Introduction

The global economic crisis has provided regulators with an opportunity to fundamentally restructure the approach to risk and regulation in the financial sector.

The international members of the Basel Committee on Banking Supervision have collectively agreed on reforms to “strengthen global capital and liquidity rules with the aim of promoting a more resilient banking sector”. This is what is generally known as Basel III.

One striking feature of the transition to Basel III is the extended period allowed for implementation. Some features of Basel III may only be fully implemented by 2019 and some features such as the steps intended to be taken to minimise risks relating to systemically important financial institutions i.e. the To Big to Fail issue, may never be implemented.

What is the reality of Basel III

Initially, national regulators from various jurisdictions disagreed on many aspects of the implementation of Basel III. In the end the basic principles were agreed upon but not without some compromise.

During the discussions, regulators in the West were focused on the need for increased buffers for both capital and liquidity. While in the East, more focus was placed on the need for comprehensive risk management, enhanced stress testing and alignment of risk and capital management with the core part of a firms strategy.

The result of these differences is “supervisory discretion”. This implies that some jurisdictions may apply a more detailed and rigid interpretation of the requirements of Basel III than in other regions. Some regions may not ever implement the full suite of Basel III requirements.

Will there be an uneven playing field in the regulatory space going forward, most definitely.

What are the key differences and how will it impact strategy

Some banks set ambitious deadlines to achieve compliance with Basel III. Early implementation is seen by many as a competitive advantage, a way to demonstrate soundness to regulators as well as the market. These banks see potential reputation risk at play and if perceived as to slow to implement the requirements of Basel III they may be viewed as unsound.

Under the new Basel III framework, common equity requirements are in some instances more than double than before. This leads to a significant reduction of available capital required by a bank to do business. In addition, increased charges for the risk weighted assets of a bank may further restrict the extent to which they may do business. Therefore, the combination of additional capital requirements as well as higher charges for the risk inherent in the assets created by banks, will in due course impact on the return on equity (ROE) by banks. The extent of this impact is uncertain but it will be due to the roll out of Basel III and depend on the operating models of each bank.

The riskier a banks business or the assets it creates, as perceived by regulators, the greater the capital requirements will be under the Basel III regime and the higher the costs incurred by a bank will be. In response, banks business models will be reshaped by these more stringent requirements. As the business models of banks adapt to the impact of Basel III they may have to revert to a regime similar to one that operated over a century ago. This is a model under which there was limited competition that resulted in much less innovation in financial services.

This adaptation by banks may however open up opportunities for competition from an unlikely source. The shadow banking sector and its ability to innovate may fill in the gaps arising in the market left by banks. This innovation is already clear in the retail sector as retailers such as Tesco create Tesco Bank and Walmart enter the pre-paid card market. As major retailers enter the market for financial services previously occupied exclusively by banks, the question arrises whether consumers should avail of their services because these retailers are of course unregulated and do not need to abide by the provisions of Basel III. As more consumers switch to avail of these services, it is unclear whether its a lower cost choice or if its because they are disgruntled and no longer trust banks. Either way, it is more competition for banks who may end up loosing customers and revenue if they do not innovate.

Alongside the proposal for increased regulation in the areas of capital and liquidity is a debate around the degree of intensity of supervision that supervisors will apply under the Basel III framework. Enhanced supervisory practices are expected to be a major focus going forward as Basel III is implemented. In addition, the choice of regulator to effect change in banks business models as a way to drive structural change in the industry or to enhance their supervisory efforts to make sure that economic failures are contained are expected to have a huge impact upon each institution.

Amidst all the debate around Basel III, it’s worth noting that the fundamental approach to determining credit risk-weighted-assets has not changed. The approach by regulators remains a risk-based capital regime. Therefore, regulators will continue to focus on risk management and governance as key requirements to underpin a robust financial sector.

Conclusion

Clearly, market consensus is that Basel III will not be the answer to all the problems experienced since the financial market crisis blew up the world. It does however go a long way in addressing excessive risk taken on by banks. It follows that institutions that are affected by the implementation of Basel III must keep a flexibility about themselves to accommodate years of fine tuning and still more future reforms. Banks earnings will diminish if they do not become more creative and markets that are deserted will be occupied by competitors from unlikely industries who are unrestrained by Basel III.

Banks should be weary of competition in the financial sector particularly as the higher cost of being regulated as a bank kicks in as Basel III rolls out. Retailers who begin to offer services in competition with banks should note that it’s only a matter of time before regulators step in and begin to regulate their activity with similar constraints as banks.