Tenth International Seminar on Policy Challenges for the Financial Sector
Towards a Brave new World – Reshaping Financial Regulation
Key Note Address
June 4, 2010
Post Crisis: Selective Perspectives on Regulatory Reforms and Financial Stability
Dr. Shamshad Akhtar
Middle East and North Africa
The World Bank
1. The World is emerging from an unprecedentedsystemic crisis that followed the bursting of a global financial bubble. The consequences of the crisis have been felt in virtually every economy, regardless whether it participated in the risky behaviors that precipitated the boom-and-bust cycle. Europe’s mounting sovereign debt worries are a forceful reminder that significant downside risks remain and continued policy responsiveness is in order.
2. In my remarks this morning, I propose to discuss the key elements of the post crisis agenda of regulatory reforms and their implications for developing countries – making the point that the financial structure and regulations adopted did safeguard some of these countries but that there is significant advantage them countries to adopt these emerging regulatory reforms. Changes in regulatory reforms are a necessary but not sufficient condition for crisis prevention and preparedness. Aside from these reforms, it is also critical for governments and central banks to strengthen the financial stability frameworks and I will discuss some key elements of these frameworks. But first let me say a few words on the scale and severity of the crisis to set the stage.
Scale and Severity of Crisis
3. Despite some good news, the global economy is not yet out of the woods and vulnerabilities remain even though the magnitude of global and national policy response has been substantial and unparalleled. Policy responses have ranged from massive monetary stimulus (whose unwinding will have its own challenges in coming years) to firefighting the solvency crisis both at the individual firm and systemic levels through closures and restructuring and supervisory actions. This is largely because the scale and severity of this round of financial crisis was unprecedented and the crisis did have some specific features.
- One, systemic risk was allowed to accumulate for many years in what was perceived as sophisticated, well-regulated and well-supervised financial systems with complete faith in the markets;
- Two, the regulatory frameworks were tweaked but endemic problems of pro-cyclicality and regulatory arbitrage were allowed to persist and were magnified by over-leveraging;
- Three, supervisors did not identify risks early enough, and nurtured excessive dependence on self regulation of banks and nonbanks;
- Four, the consequences of shifting of risk to under or non-regulated institutions was underestimated as was the degree of the interconnectedness of large financial conglomerates which induced systemic risk across sectors and boundaries; and
- Five, financial gatekeepers/market participants failed to exert sound banking governance and market discipline. The prices of traded bank debt, traded bank equity, and bank CDS spreads did not move significantly until the second half of 2007, when it was too late.
4. Abstracting from the diagnostics and consultative processes, global efforts have been underway at different forums G7, G20, FSB and BCBS etc. to draw lessons and develop consensus on reforms of regulatory frameworks. This is by no means going to be a simple process given structural differences in financial markets, their size and complexities and different local conditions and approaches/views on specific issues. It is no surprise then that advanced countries continue to debate stricter versus lighter responses to regulatory reform, while developing countries argue that their financial markets and institutions have different business models that rely on more stable sources of funding and revenues, e.g. deposits and interest incomes rather than leveraging capital through riskier products. Whatever the differences, I would not advocate complacency among developing financial markets since they have their own typical vulnerabilities. A few are listed below:
- inadequate liquidity frameworks and tools;
- excessive reliance on short term funding sources;
- capital and loan loss and provisioning rules;
- underdeveloped and under-supervised nonbank segments; and,
- weaker risk management practices.
5. Regulators and supervisors have also come under scrutiny and both the single versus multiple regulatory models proved to be inadequate to prevent or curb the systemic crisis. There is clear recognition that both regulations and supervisory structures need to be altered to avoid the future recurrence of such episodes. Still, one has to recognize that crises are inevitable and will continue to surprise as markets continue to grow and innovate. Regulators will need to have dynamic frameworks and evolving capabilities to be a step ahead of markets. They also need to strengthen their role in financial stability and reforming and effectively enforcing financial regulation and supervision without stifling markets.
Financial Regulatory Reforms – Implications for Developing Markets
6. The G-20/FSB and the consultative documents circulated by the BCBS reflect efforts to get at the root cause of systemic risks, including, inter alia, measures to address pro-cyclicality, regulatory arbitrage and interconnectedness, while propagating sound bank governance.
7. The global consultative process on regulatory reforms is impressive but not fully inclusive. The developing countries, especially those not belonging to the various global forums would benefit from greater clarity and better dissemination on the scope, application, and implications of the proposed reforms so that central banks can prioritize given their limited capacities to ensure proper compliance. While developing countries have undoubtedly much simpler financial structures (no shadow banking systems, no complex securitization chains, no derivatives markets, much less developed NBFIs including hedge funds) they are still subject to severe systemic risks, as demonstrated by the experience of Central Europe and the GCC countries.
8. In moving forward, a few of the core new regulatory reforms being launched are relevant for developing countries.
9. First, improving the quality, consistency and transparency of capital rules that involve strengthening of core tier 1 (equity and reserves) and increases in minimum capital ratios are relevant for most financial institutions in developing countries. Currently these primarily rely on equity and reserves and have rarely issued nontraditional instruments but it is significant that these banks seem to have a comparatively conservative capital base. More capital will help sustain their growing economic and credit needs. However, an issue that may have been overlooked relates to the difficulties that some host supervisors experienced in trying to call for capital injections in the subsidiaries of international banks. An adequate distribution of capital across the subsidiaries of international banks will help to ensure that risks taken locally are supported by the capital that is legally located in the subsidiaries. This could contribute to more resilient subsidiaries and better risk management practices at the local level.
10. Second, introducing and implementing proper defined leverage ratios should not pose difficultly at the present time. Going forward, it will help reduce the future risk of excessive leverage in these countries, both at the individual and systemic levels.
11. Third, introducing Global Liquidity Standards through liquidity coverage ratios, which include a narrow list of liquid assets such as cash, government bonds and high quality bonds, to cover stressed funding needs to help banks withstand severe stresses over 30 days; and a net stable funding ratio to help avoid excessive reliance on short-term wholesale funding. This proposal would harmonize liquidity requirements and address some of the problems observed in the recent crisis, such as rating downgrades, loss of wholesale funding, partial deposit run offs and off-balance sheet draw downs. In the final design of liquidity requirements, flexibility and supervisory discretion is needed to define or lengthen implementation periods for this set of recommendations; notably several developing countries’ banks – exceptions being the GCC and Eastern Europe markets – have (a) reasonably managed liquidity and institutions that do not rely on wholesale funding, (b) maintained conservative loan to deposit ratios, and (c) carried no or limited off-balance sheet activities. The proposed rules also reward countries with explicit deposit insurance schemes. This may have merit but will penalize countries which maintain implicit schemes, as a matter of policy choice, or because explicit schemes are seen by some as incompatible with Shariah law. In this regard, it is important to verify that these countries have introduced arrangements that compensate for the absence of a formal explicit scheme for liquidity purposes.
12. Fourth, enhancing risk measurement and coverage in the Basel II framework is warranted and involves increases in capital requirements for activities that entail risk (trading book) that were insufficiently captured by the previous regime. The proposal closes an important loophole but this is not expected to have a major impact in most developing countries, given their relatively smaller capital market activities, including less intensive use of derivatives.
13. Fifth, reducing procyclicality through more forward provisioning requirements will prevent the late recognition of credit losses observed during the crisis. Under an IASB proposal, adoption of an expected loss model would require starting booking provisions at credit origination (rather than at default), based on expected losses. This would mean lower incomes during a boom followed by lower provisioning charges during a downturn. However, this requires detailed data and strong risk management capacity, while many countries are already struggling with the implementation of their simpler provisioning rules. A more realistic response which deserves attention could be to introduce at a global level simplified loan provisioning standards as a first step. Going forward, more ambitious proposals could be implemented. In this regard, some propose to introduce dynamic provisioning with banks building up general provisions in good times that they can then use in bad times. Some Latin American countries have introduced dynamic provisioning, suggesting that this system can be replicated in other developing countries as well. However, while this rule could make the banking system more resilient, it cannot be expected to curb a credit boom, as the Spanish experience shows.
14. Sixth, regulating financial innovation is critical as the crisis has shown how securitization contributed to concentrating risks in non-transparent ways, how the originating banks eventually retained an important share of risk without capital protection, how securities were mispriced, and how they were transferred to special vehicles that were funded on a short-term basis. Despite this negative experience, securitization can still contribute to better risk management and allow banks to access more liquidity, provided that it is well regulated and supervised. Conservative prudential treatments, simpler products and proper incentive structures (for instance originating banks keeping a first-loss tranche) would preserve the benefits of securitization and avoid a repeat of recent experiences. In the course of our work with developing countries, we have noticed little familiarity with another instrument for funding housing loans, i.e. covered bonds. These can help reduce banks’ maturity mismatches while retaining sound incentives as credits remain on the banks’ balance sheets. Again, this is an area where the World Bank can be of assistance, as we are in Morocco at the present time.
15. Seventh, enhancing bank governance. The crisis revealed deep failures in the risk management systems of major banks, including lack of Board understanding of the banks’ risk profiles, lack of independent directors with specific risk management skills, and lack of a strong internal risk management function. Remuneration issues have also been at the center of the debate of governance reform. The reform of bank governance is being led by the BCBS, through a revision of the principles for sound bank governance, including a whole new principle on risk management. This is likely to include proposals for a Chief Risk Officer, an independent risk management unit, and possibly a Board committee dedicated to risk management, which should include independent directors with expertise in the field. These efforts are welcome and will prove relevant for developing countries as well. Another issue requiring more debate is the role of the local Board and Chief Risk Officer in the subsidiaries of international banks. In some cases, it has been observed that the Chief Risk Officer reports directly to the parent bank, bypassing the local board, and raising questions about its role and effectiveness. The World Bank has been carrying out in-depth governance assessments based on the BCBS methodology and can help in this area. Finally, the issue of remuneration is still being debated, but more specific technical suggestions to better align incentives are still needed.
16. Eighth, proper market discipline would require broad-based capacity building across banks and market participants. It is recognized today that disclosure is simply one component in the market discipline architecture, and that the failure of market discipline was also related to conflicts of interests among financial gatekeepers such as auditors and rating agencies. The debate on regulatory reform has included proposals to introduce government oversight on the quality and integrity of the rating process, but serious issues such as the concentrated structure of the industry, conflicts of interest, and regulatory reliance on ratings have not yet been adequately addressed. Improving market discipline in developing countries will prove an even more challenging task. All the problems observed in developed countries are also present in the developing ones. Moreover, the audit profession, the ratings industry, and research/consultancy industries are generally less developed. In some countries the ratings agencies are not even present. Moreover, the markets for bank debt and equity instruments are less developed and liquid for many reasons, including the lack of a solid domestic institutional investor base. This implies that, while efforts to further develop Pillar 3 should continue, the burden of financial supervision in developing countries will still fall primarily on supervisory agencies for many years. This again underlines the need for capacity building in financial supervision in these countries.
Ensuring a Sound Framework for Financial Stability
17. There is no doubt that the appropriate adoption of the proposed regulatory framework will serve as the first level of defense. However, these defenses cannot prevent crises as evident from the current crisis where the sources of crisis are multiple and originated from a combination of global imbalances, years of monetary policy easing or other macroeconomic issues and weaknesses in regulatory frameworks and oversight. In such episodes, regulatory tweaking has to be accompanied by broader diagnostics and reforms of a comprehensive framework for financial stability. At a simpler level, financial stability refers to a situation in which the financial system supports real economic activity by allocating financial resources efficiently between activities and across time; by assessing and managing financial risks; and by acting as a shock-absorber. The objective of ensuring financial sector stability seems to naturally fall within the ambit of the central bank, in part because it was perceived as a logical step given the central banks’ responsibility for systemic liquidity through their Lender of Last Resort (LOLR) operations.
18. In the years that followed the financial crises of the 1980 and ‘90s, an ever-increasing number of central banks embraced “financial stability,” either implicitly or by explicitly adding it as a second objective in their legislation. Central bankers were still new to this task, and a considerable number established financial stability units, each of which started reporting on the financial stability outlook at least annually in a financial stability report (FSR). Many of the developed countries’ FSRs that were released in the pre-crisis years were strikingly accurate in highlighting the imbalances that eventually led to the current financial crisis.
19. However, in retrospect, I feel that the problem with the pre-crisis FSRs was not so much in their diagnosis, but in their failure to follow up on the concerns that were raised: analysis was either never or insufficiently translated into corrective regulatory and supervisory policies aimed at mitigating the build-up of imbalances. This often reflected a lack of a “common language” between financial stability departments and the supervisory departments. This applies even to central banks with supervisory responsibilities. The analyses and policy recommendations of the FSRs were often too abstract and too general for supervisors to follow up on. At the same time, supervisory departments often showed only lukewarm enthusiasm for sharing their micro-level observations from the sector with the financial stability department. Also, while many FSRs were not far off the mark in identifying the factors that ultimately led to the crisis, they typically addressed them in a fragmented manner. In hindsight, we know that the underlying vulnerabilities were not only related but were also self-reinforcing. Similarly, the crisis is a forceful reminder that despite our best preventive efforts in supervision, accidents can always occur.
20. Notwithstanding these observations, it has to be recognized that many Central Banks’ mandates include price stability as well as soundness of financial and payment systems and individual institutions require development of well-articulated and integrated strategies for financial stability. A core component of financial stability frameworks is proper analysis of systemic risks that ideally involves examination of both endogenous and exogenous impacts on the economy, and an evaluation of the susceptibility to cross border contagion and monetary policy stance with a proper understanding of monetary transmission mechanisms which will be deeper and swifter depending on the size and depth of financial markets. Financial stability as such is about calibrating, influencing, and managing macro and micro prudential regulatory and supervisory regimes, backed by a consistent prudential policy toolkit, and also including proper coordination channels with the monetary policy function. Furthermore, an effective financial stability framework also includes proper information sharing and clear decision making responsibilities among all the key stakeholders.
21. Central banks are now struggling to develop a broader set of macro-prudential tools. Some of the tools that have been mentioned above, such as dynamic provisioning, are already applied in some countries. Other prudential tools that have also been applied in some jurisdictions include caps on loan to value ratios, debt service to income ratios, and loan to deposit ratios, as well as limits on currency mismatches. A larger toolkit has advantages, but the interactions among these rules and possible side effects need to be assessed, and there is no agreed framework for this, nor is there one for operationalizing the coordination of financial stability and monetary policy actions.
22. An effective Financial Stability framework also requires the granting of special powers to the Central Bank and/or the separate supervisor. This may prove challenging in some jurisdictions. Dealing with systemic risk may require the capacity to act even when micro prudential rules are still being observed by all institutions. This may raise concerns about excessive discretionary powers and violation of legal/contractual rights, an issue that was effectively observed in some Central European countries during the financial crisis.
23. Finally, an effective Financial Stability framework requires arrangements that ensure clarity of roles and responsibilities between key stakeholders such as the Ministry of Finance, the Central Bank, and other regulators. This may be achieved through the creation of a Financial Stability Committee or an equivalent construct (such as the European Systemic Risk Board). This Committee should be endowed with appropriate powers although the final responsibility for implementation may still lie with the Central Bank or the financial supervisor. The World Bank has developed a crisis simulation methodology and has conducted this type of exercise in many countries which enables them to identify possible gaps in their internal arrangements and correct them.
24. To conclude, let me reiterate that the global economic recovery, despite its vulnerabilities, is helping stabilize financial systems. The crisis has provided a good opportunity to draw lessons and better understand the causes and consequences of systemic crisis which stem from a combination of deficiencies in economic and regulatory policies which lack effective coordination both at the national and global levels. The role of central banks in firefighting the crisis in the short term has been quite unorthodox, innovative and by and large timely. Drawing from the lessons of the crisis, central banks and global institutions have further developed a fairly comprehensive package of amendments to regulatory frameworks and additional work is underway to align incentives and risks. Developing countries would benefit from the adoption of both of these changes which will need to be aligned with the prevailing structure of the financial sector and local conditions. More substantively, the real challenge for developing countries will lie in the development of financial sector stability and supportive data to assess systemic risks. Success in the development and implementation of financial stability would depend on effective monetary policy transmission mechanisms and effective coordination among central banks and economic agencies.