Issues in Regulation and Supervision of Banks

Presentation byDr.Asish Saha

&Dr. T S Ravisankar

National Institute of Bank ManagementPune, India

November 1, 2002Conference on Adapting India’s Financial Sector for a Globalizing World

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1. Financial Regulation

a. Objectives/Purpose of Financial Regulation

b. Special Features of Financial Regulation

c Types of Financial Regulation

d Regulatory Standards

e. Tradeoffs in Regulationf. Paradigm Shift in Regulatory Approach(Micro to Macro)g. Sources of Financial Sector Instabilityh. Macro/Micro Financial Stability/Soundness parameters i. Liberalisation and its impact on Regulation

2. Financial Supervision Supervisory requirements and powers:

3. Emerging Issues in Regulation and Supervision

4. Indian Perspective a. Evolution

b. Three-pronged approach of the Indian Regulator c. Regulation & Supervision : Major Issues in the Indian context5.Conclusion

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1. Financial Regulation

“Financial stability is crucial for sustained economic

growth but this cannot be achieved without strong

financial systems. Even with sound macroeconomic

management, weak financial systems can destabilize

local economies, making them more vulnerable to

external shocks, and may threaten global financial

markets.” (Financial Stability Institute)

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One of the fundamental responsibilities of the government of any country is to foster economic growth and social welfare. Hence the need for a mechanism (regulatory framework) to ensure the strength, stability and soundness of the financial system/markets

A. Objectives/Purpose of Financial Regulation - Maintaining the stability of and confidence in the financial system by ensuring the solvency and financial soundness of financial institutions; ensuring the smooth operation of payments mechanisms. (Prevention of systemic risk)

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-Protecting investors, borrowers and other users of

the financial system against undue risks of losses

and other damage that may arise from failures,

fraud, malpractice, manipulation and other

malconduct on the part of providers of financial

services. (Prevention of individual risk)

-Ensuring a smooth, efficient, reliable and effective

functioning of financial markets, including a proper

working of competitive market forces. (Promotion

of systemic efficiency) -OECD

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B. Special Features of Financial Regulation

-The structure, systems and processes of financial

regulation in any economy are determined by the

country’s social, political and economic forces.

- In a dynamic socio-economic environment, the

regulatory framework has to be responsive to

changes in the financial market in terms of its size,

complexity, procyclicality and volatility, and hence,

to remain effective it needs to be a function of time

and space.

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-While being sensitive to local needs, regulation has

to align itself to global concerns and maintain a

balance on an ongoing basis.

-The scope and coverage of financial regulation

expands alongwith the level of integration in the

financial market.

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-The instruments and mechanisms of regulation are

designed in response to the changes in the

behaviour of financial market and its participants.

-As the financial market operations are information

intensive, asymmetric availability of information

creates distortions which need to be counter-balanced

through appropriate regulatory mandates.

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C. Types of Financial Regulation

(i) Prevention of Systemic Risks:

a) Restriction of Market Forces:

-Price regulation: Administering interest rates,

fees and commissions; permitting price cartels;

-Direct lending control and compulsory

investment schemes

- Restrictions on cross-border capital flows

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-Restrictions on the range of activities:

specialisation of a bank; compartmentalisation of

banking/securities/insurance; separation of

banking and commerce; restrictions on cross-

border financial services.

-Restrictions on establishment (by domestic

institutions, foreign institutions)

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b) Prudential Regulation: Supervision of Balance

sheet ratios and of risk diversification; on-site

inspection and external auditing

(ii) Prevention of individual risks: quality standards

and codes of conduct; disclosure and information

requirements; deposit protection schemes

(iii) Promotion of systemic efficiency: prohibition of

restrictive business practices and cartels;

regulation of mergers & acquisitions

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D. Regulatory Standards

• Standards are good principles, practices and guidelines

(commonly accepted both at domestic and international

levels) relevant for ensuring soundness of the financial

system.

• The standards should thus cover key functional areas

like payment and settlement, accounting, risk

management, capital adequacy, disclosure and

transparency, ethics and governance, etc.

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In order to operationalise the standards, principles

in specific areas are spelt-out in general terms in

order to provide some degree of flexibility to the

supervisors in different countries to tailor the

standards to their country requirements and

circumstances. However, to facilitate uniformity in implementation

across the countries, standards are spelt out

explicitly in terms of acceptable practices on various

dimensions. (BIS initiatives)

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E. Tradeoffs in Regulation

Since regulation is a balancing act between conflicting demands (some which can also be country-specific) there is always a trade-off in its design and formulation.

a) Extent of admissible competition – determined by striking the right balance between perceived benefits and implicit social costs for various levels of competition.

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b) Permissible level of risk taking – trade off between

low economic growth with high social stability and

high economic growth (with increased risk taking)

with potential for instability.

c) Conflicting requirements of assuring soundness of

the financial system and of obtaining allocation of

resources to desired sectors.

d) Liberalised Vs. Restricted entry - Entry barriers stifle

competition and lead to complacency that limits

initiatives for cost reduction, efficiency, improvement

and innovation.

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e) Prudential regulation Vs. Micro-regulatory controls

Micro regulation amounts to intrusion in day-to-day

functioning of the players as against the selective

interventions (prudential regulation) whenever and

wherever needed.

f) Helping hand Vs. Hand-grabbing – Helping hand

approach aims to ‘insulate’ institutions from failure

through a protective umbrella of entry barriers,

restriction of activities, deposit insurance coverage

etc., and by providing appropriate guidance.

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On the other side, in hand-grabbing approach,

regulatory prescriptions are mainly decided by vested

interests of various socio-political constituencies

rather than by considerations of systemic stability and

soundness.

g) Extent of ownership and control of financial entities -

Domestic vis-a-vis Foreign ownership

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h) Government Vs. Private ownership of banks

Government ownership facilitates socially desirable

investments including strategic long-term investments

that may yield beneficial returns only in the long-run.

Private sector initiatives, however, are generally

directed towards sectors which are likely to produce

immediate returns of higher-order.

Also, Government ownership inspires greater public confidence in a financial institution.

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F. Paradigm Shift in Regulatory Approach (Micro to Macro)

“If the objective is to design a regulatory framework that

is able to act as a safeguard against financial instability, a

shift of perspective from individual institutions to a

system level is essential.” (Gugerell)

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Macro-regulatory approach aims at containing the cost of systemic failure to the economy and ensuring the continuity of financial intermediation function without any serious disruptions. At the other end, micro-regulation addresses the issue of limiting failures of individual institutions.

•In crisis situation each individual bank is likely to take defensive stance which may be acceptable under micro-prudential regulatory perspective. However, in the process, the financial fundamentals of the banking system as a whole may become weak which goes against macro-regulatory expectations.

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G. Sources of Financial Sector Instability

“Irrational exuberance of financial sector during boom

period and herding behaviour both during upswing and

subsequent downturn” (IMF)

Market imperfections that hide the real risk profile

embedded in the system

Weaknesses in the supervisory and regulatory

mechanisms that perpetrate irrational risk-taking by

individual players

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Weak public administration/governance

• Lack of Supervisory independence

• Government involvement in the financial sector

(Directed lending to unviable propositions at artificially

low rates of interest; Cross-subsidization affecting

earning potential of banks; Fiscal deficits financed by

borrowings from Central Bank).

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H. Macro/Micro Financial Soundness & Stability

Parameters (quantitative and qualitative)

CAMEL parameters, Sensitivity to market and

operational risks, Quality of Human Resources, Financial

Innovation, Level and scope of Technology usage, Brand

Equity, etc.

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I. Liberalisation and its impact on Regulation

• In the early eighties, Globalisation, Liberalisation and

Deregulation were advocated in tandem in the

international financial arena as key drivers of

economic growth Cross-country studies,however,have established a

linkage between financial development and economic

growth on the one hand and financial liberalisation and

financial fragility on the other.

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Countries which have liberalised their economy

without putting in place strong regulatory frameworks

have been found to be more vulnerable to crisis

situations, thereby reinforcing the need for

re-regulation rather than deregulation.

Capital account liberalisation without suitable filtering

mechanisms for controlling the inflows and outflows

and their term structure and usage, precipitated

liquidity crisis and the crisis of confidence in the

system in the affected countries

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Excessive capital inflows and the risk of reversal seen

in the crisis cases have created a clear need for

“source country regulations” that will discourage

excessive reversible capital inflows

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2. Financial Supervision• Ensuring systemic stability is one of the core

functions of the supervisor. As such regulation and

supervision are complementary to each other.

• Supervision entails monitoring whether banks are

functioning within the set regulatory boundaries and

initiating appropriate corrective actions in cases of

excessive deviation from the prescribed norms.

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• Supervisory requirements and powers: - Independence in Power/Authority- Sufficient resources for carrying out the functions - Loan classification stringency - Provisioning standards- Diversification Guidelines - Prompt Corrective Action powers - Regulations on information disclosure - Fostering healthy competition- Monitoring of banks

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• It is now well recognised that various banking risks

cannot be looked at in isolation and that there is a

close linkage and reinforcement amongst credit risk,

market risk, liquidity risk, forex risk etc. Thus an

appreciation of these inter-linkages is emerging as the

basis for future supervisory emphasis.

Reliance only on capital adequacy standards have been

found to be inadequate. Supervisory attention is

accordingly getting directed towards monitoring

specific risk exposures of banks and taking an

integrated view of their risk profiles.

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• There is a shift of supervisory focus away from

monitoring prudential ratios for individual risks to

evaluating the overall risk profile of a bank to assess

the strength and sustainability of its financial

performance.

Setting broad guidelines for managing risk and

assessing internal risk management practices of

individual banks are the two major planks of the new

supervisory approach.

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3. Emerging Issues in Regulation and Supervision

i) Growing capital flows across the world in volume

and speed and almost instantaneous movement of

such flows (facilitated by technology usage)

- How to track the flows and manage the impact of

these flows?

- How to build an insulation against short-term

exceptional flows?

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ii) Emergence of new types of products, services and

instruments on a continuous basis (surfeit of

innovations)

- How to assess their positive/negative contributions

to stability, strength and soundness of the financial

system?- How to assess their risk potential?

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iii) How to ensure better transparency in markets’

functioning given the blurring boundaries between the

different segments of the financial market?

iv) How to assess the risk profile of large universal banks

(financial conglomerates)?

v) How to ensure coordinated-regulation of such entities?

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4. Regulation and Supervision: Indian Perspective

a. Evolution

A strong point of the Indian experience has been the

gradual deregulation and slow liberalization in stages.

Parallel prescriptions of checks & balances has in fact

protected our system from internal crisis and also

insulated us from contagion effects of the financial

crises in neighbouring countries.

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b. Three- pronged approach of the Indian Regulator

- Reactive : response to unforeseen crisis/boom

situations(domestically manifested or externally

triggered)

- Preactive: Preparing the financial system and guiding

the same by phasing out introduction of new

standards already accepted but to come into force in

future.

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- Proactive: Exerting influence during the formulation

of norms/standards in global fora (like BIS) to take

care of the socio-economic concerns specific to our

country and to protect the long-term interests of the

domestic banking/financial system.

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c. Regulation & Supervision:

Major Issues in the Indian context

i) Regulatory and Supervisory functions to be separated

or combined?

ii) Regulatory coverage to include all institutions/

organizations accepting public deposits and/or all

institutions involved in any of the banking activities?

iii)Whether regulator should continue as a member of the

Board of a public sector bank?

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iv) How to design preventive regulatory measures - to maintain and safeguard the confidence in and integrity of the financial system

- to prevent possible fund flows from undesirable entities (Customer due diligence)- to assure the security and integrity of payment and settlement systems.

v) Resolution of the conflict of RBI being owner as well as regulator of institutions like SBI.vi) Should offshore banking units of commercial banks be under the purview of domestic supervision and regulation?

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5.Summary of Observations

• Given the current stage of development of the financial

sector in India, the transition from a micro to macro

prudential standards (as envisaged at the global level)

should be paced-out in a phased manner as is presently

being pursued by the Reserve Bank of India.

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Overall funding requirements of the country have to be

met by a judicial balance between internal resource

mobilisation and liberalised external funding.Keeping

in view other country experiences in this regard, the

regulatory and supervisory role would be to establish

appropriate prudential standards for this purpose and

monitor the same on an ongoing basis.

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Under the globalising conditions of the modern world,

the major role of a regulator would be to mediate

between diverse expectations of various economic

interest groups (domestic and international). This will

ultimately determine the extent of regulatory control

and the approach towards regulation.The situation is

more pronounced in the Indian context making the job

of the Indian regulator more demanding

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There is a need for moving towards incentive-based

regulation and supervision that may encourage

prudent behaviour by individual banking institutions,

and lead to a corresponding reduction in the cost of

maintaining a safety-net.

Supervision needs to play a watchdog role to see that

super-competition does not lead to total erosion of

financial fundamentals of the individual players.

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In view of the complexity and opacity of the financial

market, the collection and processing of relevant

control data should be at a much accelerated pace-

preferably in an on line mode.

Explicit cost of regulation to the supervisor and the

implicit cost to the regulated needs to be kept in view

while determining the extent and depth of regulation

and supervision

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Liberalised environment opens up multiple channels

and mechanisms of financial resource transfer across

the countries. Hence, there is an imminent need for a

single authority vested with the powers to monitor and

control all such capital flows. However, it needs to be

recognised that it would be difficult to control the

volatility expectations arising out of free information

flows across the markets.

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Due to increasing convergence in the activities of the

market players and the resultant diffusion in their

accountability, there is a need for explicitly spelling out

the supervisory domains of different regulators. To ensure continuing financial stability and soundness

of the system at the aggregate level, there may be need

for taking drastic measures against delinquent units.

The regulator should be accordingly empowered to

force closure/merger/restructuring of the ailing units

as demanded by the situation.

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“The availability of mechanisms which can ensure that

banks are soundly governed and thus that both

technical and moral mismanagement is avoided, is the

decisive pre-requisite for successful financial system

development.” (Winkler A) While reform initiatives address the technical aspects

of sound management, there is an equally strong need

for ensuring adherence to good corporate governance

practices amongst the financial players. Indeed ,

“sound corporate governance must be regarded as the

very heart and motor of financial system

development”. (Winkler A.)

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Effectiveness of the Financial Sector’s contribution to

economic growth and development will be determined

by its efficiency in the allocation of the mobilised

savings in competing projects. In the context of a

developing country like India, the allocative efficiency

was sought to be established by regulatory prescription

of directed credit flows with an element of built-in

subsidy, especially in its early stages of economic

development.In the changed economic context, this

approach needs a relook.

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Essentially regulation and supervision should be

proactive and be a step ahead of the market

innovations and developments.

Competency level of the supervisor has to be atleast

equal if not higher than those of the regulatees for

effective supervision.

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To conclude,

Regulation and Supervision will have to be ultimately

concerned with (borrowing the words of Dr.Y.V.Reddy)

“Maintaining a convincingly efficient and stable

financial sector”

and

“ Conforming to the extent possible to international

practices”

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Thank You